In my last article, I started to identify and discuss certain aspects of the main risks associated with pension drawdown contracts. I concentrated on the risks to a drawdown client of market interest rates falling before he buys a conventional annuity with his fund.
It is clear that annuity rates will generally fall as interest rates fall, meaning that the client will secure a lower level of pension income than he might have anticipated when he first entered into the drawdown contract.
However, it should be noted that the client is getting older during this period so that, in general terms, the same amount of fund should be able to secure a higher level of annuity.
Thus, I highlighted what might be termed the cross-tolerance between downward annuity pressure caused by falling interest rates and upward pressure due to ageing.
To highlight this principle and the two further principles I will discuss in this article, I noted a simple extract from the Government Actuary's Department's male tables, which were designed to mirror quite closely market annuity rates at given ages and levels of interest rates (right). I then noted the trend in annuity rates for a client at each triennial assessment if interest rates were to fall (opposite).
Throughout this short series of articles, I have assumed a market interest rate of 10 per cent at outset as a convenient illustration. Note, however, that exactly the same principles will apply whatever the initial starting rate.
Now, I have briefly revisited the main principle of my last article – the loss per £1,000 of fund (or absence of an overall loss, depending on the cross-tolerances) due to interest rates – as it is an excellent starting point for the next main risk factor inherent within drawdown contracts It must be remembered that a fall in the value of the member's fund will, depending on the size of the fall, result in a reduction in the eventual annuity buying power, especially if the fall happens at a time when interest rates are also falling.
This simple and obvious statement leads to the realisation that the client's ongoing GAD limit for his drawdown strategy will depend on the interaction of the value of his fund and prevailing level of market interest rates.
Noting again the simple extract from GAD tables shown above, and continuing our earlier example of the 60-year-old male with interest rates at 10 per cent, if interest rates remain unchanged by the time be reaches 75, his GAD limit/annuity rate will have increased from £119 per £1,000 of fund to £167 per £1,000. The obvious observation is that if the client can maintain the value of his fund at the same level as the date he started the contract, he will be able to buy a much higher annuity.
Put another and, I would suggest, more interesting way, he could tolerate a fall in his fund to 119/167ths and maintain the annuity's buying power.
Thus, a fund totalling £100,000 would have a GAD limit at age 60 of £11,900 (£119 per £1,000 of fund). If the fund then fell to 119/167ths of £100,000, that indicates a reduction to £71,257 which, at a GAD/annuity rate of £167 per £1,000 at age 75, would give an unchanged limit/annuity of £11,900 a year.
This means that the fund could fall by almost 29 per cent without reduction in the GAD limit/annuity buying power.
We have in the last paragraph started to identify what might again be termed cross-tolerances but this time between investment performance and ageing, in contrast to interest rates and ageing.
These cross-tolerances can be continue to be calculated as in the table (above right). It may be useful to check against the previous tables how each calculation has arisen.
In fact, as this table shows, we can illustrate a combination of all three cross-tolerances (ageing, investment performance and interest rates).
We are now able to identify that the member can tolerate, for example, a 3 per cent fall in interest rates and a 16.8 per cent fall in fund with no loss to the eventual annuity purchasing power.
This is surely a more useful and professional alternative to simply recounting to the member or prospective member a general statement that there exists an interest rate and investment risk.
Interestingly, this tolerance to fund and interest rate is more noticeable when prevailing interest rates are at a low level such as are currently being experienced.
Before summarising the importance and possible uses of these concepts, principles and observations, a few words of caution are in order. First, GAD limits do not match market annuity rates exactly for a number of reasons which affect annuity rates on an ongoing basis but do not affect GAD limits.
These include the competitive position and desire of insurance companies and fluctuations in life expectancy.
Thus, for example, annuity providers might reduce their annuity rates in future, irrespective of any fall in interest rates, most likely, perhaps, because of generally increasing life expectancy or because they find themselves with fewer annuity buyers in a poor state of health to subsidise those who are likely to live longer.
Thus, care must be taken in presenting the certainty of a final assumed annuity rate. Perhaps most important, it appears that life expectancy is likely to continue to rise over the foreseeable future, exerting continued downward pressure on annuity rates regardless of the level of market interest rates.
This is an issue that I will discuss in more depth in my next article.
In this article, I have concentrated on the tolerance to risks from falling interest rates, falling fund value and, to an initial extent, falling annuity rates due to increasing life expectancy. It has not been intended as a full discussion of all the major aspects of a drawdown strategy.
Therefore, in my next article, I will not only develop the issue of life expectancy in more depth but bring together these and other risk or reward factors in the drawdown strategy and make suggestions about how they might be presented to clients and prospective clients.