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Capital solution to drawdown dilemma

Falling interest rates and longer mortality assumptions have resulted in a gradual decline in annuity rates over the past 10 years. A widespread debate about the value of annuities in the consumer press – mostly from an extremely negative viewpoint – has raised the profile of alternative means of retirement provision, with Isas and deposit accounts frequently touted as better options.

While there is no doubt that the annuity regime could benefit from considerable modernisation, it is depressing to see such a one-sided debate in the consumer press. For some people, particularly the risk-averse, there is undoubted value in the cross-subsidies and security provided by annuities.

The Treasury, while showing a very blinkered view that often appears immune to any alternative argument, has a valid concern about getting some taxation back from pensions, which offer tax relief at the full marginal rate and roll up free of capital gains tax. However, it is hard to see how creating a transfer market and allowing short-term contracts will enable annuities to conquer the most basic problem currently faced – the generation of too low an income level.

Against this backdrop, the increased attractiveness of income-drawdown contracts is clear. The ability to take a higher level of income than could be provided by a straightforward annuity – subject to limits, of course – and the removal of the need to cash in hard-earned savings are seductive sales messages. To a client expressing a low appetite for risk, however, the question of where to invest the balance of the fund has taxed financial advisers greatly.

Much has been made of the critical yield and the need to ensure that the underlying portfolio can generate sufficient returns to counter mortality drag and the lack of any cross-subsidy from the way the income is taken. The need for a high proportion of equity exposure is clear to most. However, the route chosen by many advisers in the past has stored up huge potential problems that are only now surfacing. This, of course, was the traditional answer to the risk-averse client who wanted all the benefits of equity returns with none of the downside – with-profits.

Five years ago, with-profits seemed to make perfect sense. Annual bonus rates were significantly higher, the market was competitive and the sustainability of with-profits was rarely called into question.

How times have changed. Annual bonus rates are being cut by up to one-third in this year&#39s bonus declarations, terminal bonus rates are being slashed to reflect falls in world stockmarkets over the past two years and increased regulatory intervention and low interest rates have made the provision of capital guarantees ever harder to finance.

Frankly, it is hard to see how this product can now be justified in forming part of the underlying portfolio for a drawdown client taking even a modest level of income. How many providers are now publicly promoting the proportion of their with-profits fund held in shares and what does this say about the sustainability of the product for drawdown?

Risk consultants Barrie & Hibbert have undertaken extensive research into the minimum proportion of a drawdown fund that should be held in equities in order to outperform an annuity strategy over the longer term. Accepting that differing levels of income drawdown will necessitate different proportions of equity backing, the broad answer is around 60 per cent, assuming that mortality drag is a cost, among other factors.

Any clients with an aversion to this proportion of equity backing, who would normally seek the haven of a bond fund or with-profits, would be better off purchasing an annuity.

Given this, what are the alternatives in a flat equity market with bond yields falling even lower? How can an adviser match a client&#39s need for income with a desire to ensure that capital does not only appreciate but is protected at all costs?

One answer could be the use of capital-protected structures. Although shorter-term, open-ended funds have been used in pension provision in the past – most notably by Scottish Mutual in its Command Performance range – only recently has a provider specifically targeted the pension market with a longer-term protected product.

The NDF retirement income and growth plan enables drawdown clients to choose a fixed level of income – either 3, 5 or 7 per cent – for six years. This income is fully secured from the initial investment amount and the balance is invested in a capital-protected asset that returns this portion of the investment after six years together with 70 per cent of the growth in the FTSE 100, with no upper limit.

This is an extremely simple structure that captures investors&#39 desire for fixed income, capital security and equity upside, without requiring the IFA to take complex decisions on where the drawdown portfolio should be invested.

In future, IFAs and their clients will not be limited to off-the-shelf products offered by existing providers. Providers – or, more accurately, provider enablers such as Selestia – are tackling investment products from a new angle, designed to assist IFAs and their clients understand the nature of the investment decisions they are making.

I strongly believe this will be the way forward. After all, the key differential between one drawdown contract and another is not its charging structure but where the money is invested. Tools that help this decision are the key to success in this or, indeed, any investment arena.

The day cannot be too far away when an IFA firm can structure its own self-invested pension wrapper, charged to meet the income needs and investment selection of their clients. Only then will the IFA have the complete drawdown solution at his or her disposal.

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