Is the Government right to increase the maximum rate of income for capped drawdown?
A good number of drawdown users will be celebrating the announcement that capped drawdown limits will return to 120 per cent of GAD rates. The change announced by the Chancellor will help many pensioners to access a fairer income, reflecting their retirement needs.
While we are very pleased with the decision to increase the drawdown limits we believe there are still more changes that are needed to ensure that the regulations provide a stable and appropriate basis for retirement planning.
There is clearly a need to have a sensible limit in place to protect the fund from erosion and to maintain the income stream. There are two key factors to providing sustainable income and reducing the risk of the fund running dry.
Sustainable income risk – the need for a low volatility investment solution
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 principally for growth in the hope that it will generate a sustainable income, the risks outweigh the benefits as once the money is lost it can’t be recovered. So choice of investment is critical.
Income Flexibility and Advice
Life is unpredictable and income needs in retirement are unlikely to remain constant.
We talk about the ‘retirement smile’ meaning in the early years of retirement you are likely to need a higher income. This typically tails off in your seventies, but increases again later (for example for healthcare), so much so we estimate that, should you live that long, 92 is the most expensive year of retirement.
The increase to the income limit will allow drawdown users the flexibility to adjust their income throughout the retirement (taking more when they need it and less when they don’t). When taking action in reducing or increasing income levels it is critical the right financial advice is received to help manage the flexibility of income and to monitor investment progress.
A more realistic GAD rate
It is excellent news that the Chancellor has decided to act on the growing calls from the industry to address the problem of falling drawdown income levels. Increasing the percentage of GAD rates that can be taken will treat the symptoms of falling drawdown income and this should be welcomed. But it doesn’t cure the problem that the GAD limits themselves are no longer a true reflection of market annuity rates.
Drawdown users have taken a much bigger income hit than annuity buyers as yields have fallen over recent years.
The problem, though, is drawdown limits assume annuities are backed entirely by gilt investments. In practice, insurers weigh heavily towards investment grade corporate bonds to support their annuity guarantees.And there is a simple remedy.
Linking drawdown rates to corporate bonds rather than gilts will have two positive impacts:
It will increase drawdown rates back into line with annuity rates as intended and
It will ensure any future changes in annuity rates are reflected appropriately.
Alastair Black is head of income solutions at Standard Life
There were disappointing reductions to the annual and lifetime allowances within the Autumn Statement but there was a silver lining for pensioners with the news that drawdown income will be increased. The Government’s about turn, increasing maximum income back to the 120 per cent level it argued so vociferously against only 18 months ago, is certainly a surprise.
We don’t yet know when 120 per cent income will be re-instated as the change needs primary legislation, but a date of April 2013 looks likely.
It is clear drawdown customers are facing unprecedented times, with many seeing their income drop by 40 per cent or even 50 per cent. So I understand there is an urgent need to help these people who have seen their circumstances change so significantly.
However, we have to tread with caution. Taking the full 120 per cent income each year runs the risk funds can be diminished quickly.
And the recent history illustrates exactly that. The Government’s decision to reduce income to 100 per cent and the present historically low gilt yields both played a part in the significant income falls which customers are experiencing. But another major factor was the high income levels people were stripping out of their drawdown pots.
Taking 120 per cent each and every year meant people needed high investment returns to maintain that income. And, for most, investments have simply not achieved these high hurdle rates over the last five years.
The investment risk within drawdown increases as people age. Drawdown doesn’t benefit from the cross-subsidy available within annuities, which grows as the client gets older, reaching 3 per cent a year by age 80.
Instead, it becomes progressively more difficult to achieve investment returns in drawdown which compensate for missing out on the cross-subsidy benefit.
This can be apparent as critical yields for those taking 120 per cent income can be 9 per cent or more. And that doesn’t take into account that in more than half of cases the individual’s health is likely to be declining, meaning the ‘real’ critical yield needed to replace the annuity income they could receive on enhanced terms can be substantially higher.
Allowing people some flexibility to withdraw their pension savings when it suits their individual circumstances is a positive – whether that is within drawdown or an annuity.
But we need to ensure people understand the consequences of their actions. Stripping 120 per cent income out of drawdown is unlikely to be sustainable. So a balance needs to be struck between short-term income needs and making sure retirement income lasts a lifetime.
Andrew Tully is pensions technical director at MGM Advantage