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Don&#39t drag down drawdown

The most disappointing aspect of the Inland Revenue&#39s Modernising Annuities paper is the rejection of the possibility of lifting the age limit for buying an annuity.

Indeed, the comments in the paper leave the impression that policymakers believe there is no way a higher age limit can work.

In many respects, you are left with the impression that during the initial consultation process the Inland Revenue has been bombarded with some very prejudiced and ill-informed views on the risks associated with drawdown plans.

The main reasons for rejecting the possibility of change are the mortality drag effect and the possibility that drawdown plans could be run down prematurely leading to the need for state support.

While the paper did attempt to justify this view, it looked at this issue from a limited perspective and did not take the next step of considering how drawdown might work if you got rid of the requirement to buy an annuity altogether.

Due to the way that the Inland Revenue has viewed mortality drag, it is hardly surprising that further changes to the annuity purchase age have been viewed negatively.

The reason that mortality drag arises is that drawdown investors do not benefit from the mortality subsidy annuities would deliver during periods of deferment.

No one would deny this, but many would argue there is another side to this issue that has been completely ignored. This is that drawdown investors are compensated for this effect in two ways.

The first benefit is that the remaining drawdown fund remains fully available to the drawdown planholder&#39s beneficiaries on death.

However, the less obvious, but potentially more powerful, benefit is that if circumstances change, the drawdown investor can adjust the annuity they finally buy while other investors will be stuck with the annuity they bought at the outset.

The circumstantial changes that have the biggest imp-act would be the death of a spouse (would not need to pay for spouses&#39 benefits) and health deterioration (may take the view that escalation is not worth purchasing or that an impaired annuity may be more appropriate).

Having said that, the key point to appreciate is that mortality drag is only an issue if you finally buy an annuity. So while extending the annuity age by five years may well compound the issues associated with mortality drag, removing the age limit so you do not have to buy an annuity at all would actually solve it.

Both these perspectives are best considered by looking at how drawdown plans have actually performed.

To do this, the annuity rates assumed are based on FSA annuity rate tables adjusted by the prevailing Gov-ernment Actuary&#39s Department gilt yield.

This is important on two counts. It allows an annuity equivalent to be calculated so that the example can assume withdrawals from the drawdown plan that match the payments from an annuity purchased at outset.

This figure can also be compared with the residual annuity that the remaining drawdown fund can purchase at any given point during the comparison. This helps to determine how well drawdown would have worked taking into account changes in market conditions over the life of a drawdown plan.

Table 1 considers an example that looks at the six-year period from January 1, 1996 to January 1, 2002. This covers a period of significant decline in annuity rates and the recent downturn in world stockmarkets.

This example shows that rather than diminishing in value, the drawdown plan increased by 15 per cent over the period.

Although the annuity the residual fund could purchase is slightly less (8 per cent) than the annuity that could have been purchased at outset, this is due to changes in gilt yields rather than the underlying performance of the drawdown plan.

Mortality drag may have had an effect but this negative has been offset by the death benefits and the gains that would be achieved if there had been circumstantial changes over the life of the drawdown plan.

As this fund has been a strong performer in its sector, we repeated this exercise for the Skandia Henderson managed fund which produced below-average performance over this period.

Although the outcome showed the pension produced by the residual drawdown fund would have been 23 per cent below the annuity that could have been purchased at outset, the fund value remaining was still £95,293.

This confirms that the fund value has maintained most of its value over this period and is not facing any imminent risk of being run down to zero, especially bearing in mind the current stage of the investment cycle.

Hence, even a below-average fund is only under pressure over this period because it still has ultimately to buy an annuity. In addition, the loss in pension income terms would also be offset by the extent of the death benefits that could be provided by the drawdown plan.

The flip side of this, of course, is that the plan could have achieved very good investment returns.

To do this, we assumed a relatively conservative allocation but selected a group that has had a very strong performance to demonstrate just how big the performance impact could be.

Using the same example but assuming 50 per cent in Fidelity institutional long gilt, 25 per cent Fidelity special situations, 13 per cent Fidelity Europe, 6 per cent Fidelity America and 6 per cent Fidelity South-east Asia, the outcome shown in Table 2 would have been achieved.

The point that the policymakers need to take on board is that the poor performance of some drawdown plans is normally easily explained.

In many cases, the common denominator is that policyholders have either with- drawn too much, have been invested too heavily in traditional with-profits plans or gave up guaranteed annuities in return for an Equitable Life drawdown plan rather than because the concept is flawed.

I suspect that most of the negative attitudes from drawdown is because of factors such as these and that the Inland Revenue&#39s call for more fresh thinking and innovation, should extend to drawdown as well as flexible annuities.

While lifting the age limit on annuity purchase would carry risks, the approach to this should be to change the structure to manage these risks rather than to run away and do nothing about it.

If preventing drawdown plans from running down is a key issue, then somebody should at least look at how the existing drawdown structure can be tightened up.

All our research and experience suggests that a lower maximum and more frequent reviews would address the Inland Revenue&#39s issues and would create a platform for greater numbers to enjoy the benefits of drawdown throughout the retirement period.

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