In December’s Autumn Statement, the Government said it would not be changing the GAD tables for calculating income withdrawal rates used for capped drawdown, as those withdrawal rates are a “reasonable match to annuity rates”.
But is that reason enough not to change?
As annuity rates come under scrutiny, the other methods of accessing retirement savings are increasing in relevance. It is my view that GAD tables, while originally justified, are no longer fit for purpose.
When the Government removed the compulsion to annuitise at age 75 in 2011, reform and simplification of capped income limits were overlooked.
Unlike an annuity, which guarantees an income for the rest of one’s life, the Government’s concern with income drawdown arrangements is the potential for pensioners to run out
There are three risks that need to be addressed when devising an appropriate retirement income solution for clients. They are longevity, inflation and sustainability of income. An annuity can take care of longevity but it generally does not cope well with inflation. An invested solution, if well managed, can ensure income withdrawals are sustainable only if the longevity risk is mitigated.
The current maximum income that can be drawn from a capped income arrangement is calculated as 120 per cent of the basis amount of a relevant annuity, as defined by the Finance Act 2004. To obtain the basis amount, the value of the assets held in the capped income drawdown arrangement is multiplied by a factor derived from tables produced by the GAD. The appropriate factor is found by applying the current yield for 15-year gilts to the age of the individual.
This calculation is applied on entry into drawdown and on each third anniversary up to age 75, then annually. This method can lead to bizarre results, however.
Consider an individual who is phasing into drawdown. The drawdown fund is acting as it was designed to do, yet their maximum income reduces purely because of the movement in 15-year gilt yields. Similarly, a poorly performing portfolio can appear to be performing better than it is because an increase in 15-year gilt yields results in more income that can be withdrawn.
When a consumer who has made considered choices about their retirement planning is suffering detriment through no fault of their own, can we say that the GAD tables are a suitable method for providing the best outcome for calculating income drawdown rates?
So what should guide the search for an alternative?
In a word, simplicity.
To devise a simpler approach to calculating income from a drawdown arrangement we need to first look at the five reasons why drawdown is seen as a viable solution for some clients:
1: Provision of better death benefits than will be available under an annuity at no cost
2: The potential for higher income than is available under an annuity due to investment in higher-risk assets
3: As a supplement to an annuity whereby the annuity hedges longevity risk and the income drawdown fund is used to for a combination of benefits under 1 & 2 above
4: To have more flexibility in the income drawn to reflect lifestyle needs
5: To act as an annuity deferral mechanism
An individual who is in capped drawdown, and has designed a portfolio with one of the five reasons above in mind, should not have their maximum income dictated by the actions or expected actions of the Bank of England or the Federal Reserve Bank around the date of their maximum income review. The changes should be driven mainly by the performance of the underlying portfolio.
For reasons which include the 55 per cent tax on crystallised death benefits and more individuals transitioning into retirement, we are seeing a marked growth in phasing into retirement. An alternative should also deliver more certainty as to what will occur in the future.
Finally, because of the complexity behind the relevant annuity concept, the limit on capped income is seen by some as a Government restriction on access to their pension fund.
Any alternative should be an easy concept to understand and relevant to the risks. I suggest a new table, combining two elements to determine the maximum percentage of the fund to be drawn in any year.
The first element is the income that can be expected to be generated from an income drawdown fund. We would suggest the FTSE dividend yields are used – at 3.5 to 3.7 per cent. To this add percentage, from linear capital withdrawals over the longevity period until the date there is only a 10 per cent chance of survival. This would factor in both income generation and longevity so income should be sustainable if a well-managed portfolio is in place.
This has the advantage of relating the maximum income to important factors that are relevant to the sustainability of a drawdown fund; the income generated by the fund; if withdrawals are more than the generated income, then the capital is eroded; and whether the fund will last as long as it is needed. Although this is a simple concept, checks and balances are built in.
In periods of depressed markets, higher-income yields would not be reflected in the tables so protecting against artificially high maximum income withdrawal amounts. Similarly, underlying capital growth is not a factor in the calculation although the client should benefit from it.
The table that is derived from these two elements should be reviewed every five years to ensure income and longevity assumptions remain relevant. But these reviews will be a lot less frequent and show less volatility than the current method that changes monthly.
This suggestion is deliberately simple as I feel it is important that clients are able to more easily understand what their retirement income will look like in the future. After all, it is the client outcome that should come first.
Bob Champion is retirement product lead at Skandia