More important, I have started to highlight a method by which the extent of these risks can be quantified – either regarding individual risks or a combination of two or all three risks.
In my last article, I assessed the impact on annuity rates of increasing life expectancy, noting the continuous and almost straight-line improvement by three years per decade for males and two years per decade for females.
In particular, I observed that such a three-year improvement (for males) had almost exactly the same impact on annuity rates as a 1 per cent reduction in interest rates – both resulting in, broadly, a 10 per cent reduction in annuity rates.
In this article, I will bring all these issues together and suggest how these (arguably fairly complex) mathematical techniques can be used in the advice-giving process at the outset of a drawdown recommendation and, subsequently, at the time of period reviews.
I will start by reproducing from my last article the summary table of cross-tolerances to interest rate and investment risk derived from Government Actuary Department tables which I have, admittedly a little simplistically, taken to indicate market annuity rates broadly at a given level of underlying interest rate.
The cross-tolerance table indicates – ignoring the effect of increasing life expectancy – the tolerance within a drawdown contract – the level to which interest rates could fall, combined with the level to which the client’s fund could be depleted without the annuity purchased at age 75 being lower than could have been bought at age 60.
By way of a quick example – and then I will bring in the issue of increasing life exp-ectancy – even if interest rates fall by 2 per cent and the fund falls in value by 21.2 per cent, the annuity purchased from the drawdown contract at age 75 would be exactly the same as the annuity which could have been purchased when the client vested his pension fund at age 60.
This is, I suggest, an ext-remely important observation which, while not attempting to understate the nature or the extent of the interest rate and investment performance risks, highlights the fact that there is a tolerance to each and both of these risks – brought about quite simply by the fact that as the client is ageing during the drawdown period, his annuity rates will increase.
Bringing the risk from inc-reasing life expectancy into this (previously only two-dimensional) model, note that a threeyear improvement in life exp-ectancy within this age group has roughly the same impact on annuity rates as a 1 per cent reduction in interest rates.
Thus we can now view this two-dimensional tolerance table as a three-dimensional table. Returning to the example above, we can observe that the client could tolerate over the period of the drawdown contract a 1 per cent reduction in interest rates and a threeyear improvement in life exp-ectancy and a 21.2 per cent fall in the value of the fund.
We have now combined and evaluated the level of tolerances to all three of these main risks. However, accepting that it is highly unlikely that an adviser will want to, or be able to, explain the quantification of these tolerances meaningfully to clients, can these concepts really be of use or interests to pensions advisers? I believe they certainly can.
At the outset of determining the favoured method of providing retirement income, the adviser could, and arguably should, ascertain and quantify the client’s tolerance to risk. By this I do not only mean establishing his general attitude to risk but, more importantly, the minimum level to which the client would be prepared to see his future pension income fall.
For example, suppose the client’s fund could secure a conventional annuity of, say, £20,000 a year at age 60 but is particularly attracted by the superior death benefits offered by a drawdown contract. A leading question could then be, what is the minimum amount of pension you would be able to accept if certain factors within drawdown work against you?If the client says, for example, £15,000, the adviser has ascertained that the value to the client of the combined features of drawdown (including, obviously, enhanced death benefits, ongoing choice of beneficiary, and flexible inc-ome) equate in the client’s mind to a value of around 25 per cent of his benefits.
The adviser can then bring into the equation – in considering his recommendation – this 25 per cent tolerance alongside the tolerances we have already established and quantified in this short series of articles. Therefore, in addition to the cross-tolerances to reductions in interest rates, falling value of the fund and increasing life expectancy, the client’s tolerances are further “enhanced” by this 25 per cent acceptance of further annuity losses.
Surely, an understanding by the adviser of the nature and interaction of these risks and tolerances will help arrive at a suitable recommendation for the client.
Beyond this first recommendation, though, if the client selects the drawdown strategy for his retirement income needs, the adviser will have already established the limit to which bad things happening to this client’s situation can be tolerated.
At the end of the first year, for example, the adviser can assess the effect of movements in interest rates, changes in the value of the fund and annuity rate changes brought about by trends in life expectancy. If the combination of these three factors have an adverse effect on the value of a conventional annuity which could be bought at that age, the adviser might consider recommending to the client that he should abandon the drawdown strategy and buy a conventional annuity – albeit much earlier than age 75 which was, one would assume, the original intention.
When I have had this conversation over the years with other pension advisers, I have regularly heard such phrases as bailing out and admission of initial bad advice, indicating that some advisers believe a drawdown contract, if properly advised at the outset, should or must by definition be allowed to run its full course. I strongly disagree.
If, for example, a drawdown contract has been running for, say, three or four years, during which time interest rates have fallen heavily, fund performance has been worse than expected and annuity rates have fallen even further bec-ause of continuously increasing life expectancy, the annuity that can be purchased by the client’s fund is likely to be much lower than he could have secured had he opted to buy a conventional annuity at the outset, notwithstanding the tolerances to these risks that I have discussed over these last few articles.
If this reduction is starting to approach the level of tolerance identified by the client at the fact-finding stage, surely it would be helpful for the adv-iser to bring this situation to the client’s attention and suggest an immediate annuity purchase. If the client expresses a wish to remain within drawdown, he must then do so in the knowledge of the renewed level of future risk.
In summary, from seemingly quite complex mathematical concepts, it is possible for the drawdown adviser to offer a much more focused initial recommendation and a thorough ongoing review service based on more objectivity than has perhaps traditionally been the case.