I have always taken a balanced approach when advising clients about retirement options and have coined the term “balanced retirement”. My approach is to recognise that it is not necessarily a black-and-white choice between an annuity or drawdown and a prudent investor might consider a combination of annuities and drawdown with annuities so as to achieve a balance between secure income and flexibility.
One of the reasons for such an approach is that most advisers will steer their clients towards a low-risk annuity or higher-risk drawdown. There has until now been nothing in the middle but many people want to be in the middle.
I have been advising clients long enough to know that many want the best of worlds – a guaranteed income and flexibility. For flexibility read lump-sum death benefits.
Enter stage right the new third-way options which aim to provide investors with a guaranteed income for life and flexibility.
Insurance companies have tried to design annuities that have flexibility but current regulations simply do not allow this. All credit to those companies that have designed innovative annuity products but they have not gained mainstream appeal.
The new third-way products approach the problem from a different angle. Instead of trying to make an annuity look like drawdown, they try to make drawdown look like an annuity by providing a guaranteed income for life.
In the US, many variable annuities have a guaranteed lifetime withdrawal benefit option. Variable annuities are tax-deferred savings plans. There is no tax on investment gains but tax is payable on the income payments. They have two stages – the accumulation period and payout period when investors can take income by way of an immediate annuity for a designated number of years in the form of a single lump sum or through systematic distributions. The latter is similar to drawdown.
The guaranteed lifetime income is payable regardless of investment returns and most contracts lock in investment gains annually. Investors can therefore benefit from a guaranteed income for life without actually buying an annuity. In addition, if the fund increases in value, the level of income will increase. If the fund falls, the income will remain at the level at the last lock-in. On death, the funds can be paid as a lump sum to beneficiaries.
The guarantee is provided by the insurance company through a process known as dynamic hedging and the underlying derivatives backing these guarantees are rocket science material.
There is a price to pay for the lifetime income guarantee and this is represented by an increased fund management charge. Charges differ from company to company but typically range from 0.75 to 1.5 per cent a year .
This may seem expensive but according to Moshe Milevsky, associate professor of finance at the Schulich School of Business at York University (US), many of these lifetime guarantees are competitively priced. He adds: “In 10 years, the fees on these annuities have gone from overpriced to possibly underpriced”.
I suspect that it is the additional charges and the fact that the new guaranteed drawdown products are only provided by US insurance companies that has caused some commentators to say that while investors may be getting peace of mind, they may also be buying something they do not really need at extra cost. Some commentators go further and say the companies have fundamentally misunderstood the UK market.
I think the UK is ready for these new guaranteed drawdown plans. One of the reasons why lifetime income guarantees resonate strongly with many investors in the US is because they provide longevity insurance without requiring annuitisation.
In the UK context, this means that investors can benefit from annuity-type income without giving up access to their capital. Well, at least until age 75.
There are obviously lots of differences between us and our American cousins but retired investors on both sides of the Atlantic share many of the same concerns. These are need to maintain a certain standard of living and guard against inflation, as well as the need for flexibility and control without taking too much risk.
Billy Burrows is a director at William Burrows Annuities.