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Case study: Getting risk right in retirement income

The problem: The client is approaching retirement with a collection of defined contribution and personal pension funds. He is looking to convert his savings into retirement income but is concerned about the effects of inflation but is wary of taking on too much risk himself. What are his options?

The solution: Britain’s baby-boomers are faced with a near perfect storm when they come to secure their retirement income. Low annuity rates, low inflation, increased longevity and volatile markets have all conspired to create the worst case scenario.

Recent research commissioned by Standard Life shows the main priority at retirement, for the vast majority of individuals, is sustainable secure income.

Access to funds, providing for dependants and family on death, flexibility and control also feature prominently. But only after that core income requirement has been met are these other factors generally considered.

An annuity is the most secure way of providing sustainable retirement income. The annuity provider takes the risk of providing the income.

However, it typically does not currently provide any of the additional benefits. Although there are continued developments in this market.

Quantitative easing has driven down gilt yields and in turn seen annuity rates slump to all-time lows. From 21 December the move to unisex annuity rates under the EU gender directive is likely to see annuity rates for men fall even further.

Those looking to purchase an annuity in the current climate will need a significantly greater fund to secure the same level income enjoyed by those retiring 10 years ago.

Income drawdown ticks all the boxes for satisfying all those additional financial priorities in retirement. Income flexibility, freedom to pass on pension benefits to loved ones and the ability to retain investment control and benefit from investment returns can all be achieved.

But retaining investment control means taking on the risk of maintaining the income stream.

Market volatility can have a huge detrimental effect on future income. This is amplified where volatility occurs in the early years of entering drawdown. More units will need to be encashed to provide the income when markets fall. This leaves fewer units available to benefit from any recovery.

Whilst it may be tempting to invest for growth in the hope that it will generate a sustainable income it is equally as important to protect against the risk of volatility.

Finally, flexible drawdown can remove the GAD rate shackles provided the necessary £20,000 minimum annual income requirement is satisfied. Those already in capped drawdown may have seen a significant reduction in their income as GAD rates have suffered from poor gilt yields.

Taking flexible drawdown can also improve death benefits relative to capped drawdown. Typically only enough of the fund will be crystalised to meet the current years income requirements. If death occurs before age 75 the remaining uncrystalised fund would be available as a tax free lump sum. Meeting the same level of income in capped drawdown may require crystalising the whole fund resulting in 55 per cent tax charge on the lump sum death benefit.

These are challenging times for those approaching retirement. Clients who choose drawdown will need ongoing advice on their income needs. Key to this is volatility control and capital preservation in order to weather the retirement income storm.

Alastair Black head of decumulations propositions at Standard Life

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