Drawdown as a concept has been with us since 1995. Back then, it was typically designed for more sophisticated investors who were willing to take more risk in exchange for flexibility in how they drew their assets.
Fast-forward to today and it is likely to become the default method for pensioners to take retirement income, whether sophisticated, wealthy or not.
While I speak with many advisers who understand the finer points associated with drawdown, some express concern over the complexities and getting to grips with them. Here is a summary of the key considerations…
1. Liquidity requirements and capital expenditure
The most important starting point is to ensure potential retirees have their basic subsistence level of income covered right up front. The remaining capital, once the core income needs have been covered, can then be used to provide for discretionary or deferred income and invested appropriately.
2. Longevity risk and death benefits strategy
With life expectancy continuing to grow, there is a real risk a client may live beyond the ability of their accumulated assets to generate a subsistence level of income (or after capital asset exhaustion). It is therefore prudent to plan accordingly.
In addition to income sustainability and maximisation, it is important to consider whether the client needs to leave income or a legacy for beneficiaries. This should be explored in tandem when agreeing appropriate solutions.
Agreeing time horizons is a fundamental step in the advice process when planning retirement income strategies. However, with life expectancy rising, setting a fixed strategy based on a fixed term outlook has become increasingly difficult. It is therefore vital to have regular client contact so strategies can be adapted based on market conditions and client circumstances.
4. Income shape
Establishing the shape of income required by the client can be a challenge but there a number of key factors to take into account and discuss with clients:
- Consider the stages of retirement
- Establish income requirements
- Assess the impact of longevity
As part of assessing the shape of income required, it will also be necessary to relate this to the accepted retirement advice hierarchy:
- Income and liquidity needs
- Protection for dependants
- Tax planning and arrangements for beneficiaries
5. Income sources and strategy
Clients are likely to have a range of potential sources of retirement income at their disposal so it is important to establish all available. Once established, the next stage is to understand how the client’s income requirements can be met over the agreed timescale using the sources of income in the most tax efficient manner.
One of the benefits of a platform in this regard is that if assets are held in one place it is easier to understand the potential sources of income available, utilise the range of tax wrapper/investment options and turn income streams on and off as tax planning income needs and capital preservation requirements dictate.
6. Planning against retirement ruin
Retirement ruin is a real risk that advisers should be helping their clients to mitigate against, so it is important to sense check against this risk by evaluating and discussing how the impact of income withdrawals, investment returns and life expectancy affect a client’s pension pot.
7. Non-investment risks
Along with investment risk, it is also imperative advisers identify and evaluate the various non-investment related risks – such as inflation, interest rate changes, and legislative/regulatory risk – and form an appropriate mitigation strategy for the client.
8. Client risk profile
It will be necessary to establish the client’s risk profile and, in the accumulation phase, this typically involves helping the client to understand the potential upside and downside of investing over a given period of time. However, once in retirement, different assumptions need to be made with regard to assessing, mitigating or accepting risk.
A more prudent method therefore may be to look at results based on impact to cash flow by assessing a client’s capacity and willingness to accept a shortfall in achieving their goals.
9. Critical yields and projections
When planning a retirement income strategy for a client, it is important to undertake critical yield A (to determine the rate of return required to provide and maintain an income at least equal to that which could have been secured through an annuity) and critical yield B (to determine the rate of return required to prove the selected level of income) calculations.
10. Asset allocation and investment strategy
At retirement, the accumulated pension pot will typically be used to provide an income to the retiree. Therefore, a different asset allocation strategy is often required to that when accumulating assets.
A suitable asset mix needs to be chosen to generate income while mitigating risks, such as inflation risk and longevity risk.
While this list is by no means exhaustive it should provide some food for thought as we move towards a new era of financial planning. The final and key point is to ensure regular reviews with clients.
Jon Everill is head of advisory services at FundsNetwork