Capped drawdown is riskier than many think

Nigel Barlow

The Treasury consultation on removing the effective requirement to annuitise by the age of 75 appeared to change the retirement landscape, letting individuals deal with their pension fund as they wished.

The initial focus was on the ability to take pension funds as cash once a minimum income requirement had been secured for life. The level of the MIR means most people will not be able to take advantage of uncapped drawdown, given most pension pots are small.

More relevant is the fact that anyone with an individual pension fund can continue in income or capped drawdown for as long as they wish, after the abolition of the previous age limit of 75, beyond which a choice has to be made between annuity and an alternatively secured pension.

The ASP route was rendered unattractive for many by a tax rate on death benefit lump sums of up to 82 per cent and because maximum income was restricted to 90 per cent of HM Revenue & Customs’ annuity rate for someone aged 75.

The new rules allow income withdrawals equivalent to 100 per cent of the HMRC single-life annuity rate at any age. This will result in an increase in income at most ages over 75. The income has to be paid for in the form of additional growth if the risk of exhausting the fund is to be avoided.

There is a risk of excessive depletion of the fund at any point in income drawdown for those trying to match the income from an annuity but as age rises so does the risk as the mortality allowance in the annuity rate increases with age. Beyond 75, the allowance rises rapidly, placing a strain on an investment fund trying to match annuity income.

This can be seen when calculating a critical yield to age 80 rather than the usual 75. From age 65, the growth rate required to match annuity income to age 80 will be about 0.2 per cent to 0.25 per cent per year higher than that needed to match it to age 75, assuming an annuity is then purchased. The additional growth rate will be required every year for 15 years.

Every year of delayed annuity purchase beyond that will require a higher rate of growth as the mortality allowance within the annuity rate accelerates and all of this assumes investment returns are smooth over the whole period.

Even a short period of market decline can destroy the ability to generate the required income and leave an individual without enough to live on for the rest of their life.

Stochastic models demonstrate how cautious one needs to be in setting income limits under capped drawdown as age rises. Beyond the age of 75, anything over 50 per cent of the age 75 annuity rate is potentially unsustainable, due to the real risk that an individual may live through several investment crises and beyond the age of 100. A loss at this age would be irrecoverable.

Most people in drawdown are probably not taking the maximum permitted income but a substantial minority will be. What must be explained is the risk even those drawing as little as half of the maximum could be taking if drawdown continues far into later life.

Nigel Barlow is director of technical product development at Partnership