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Rates of change

This week, I want to look at the real nature and effect of interest rate risk. On commencing a drawdown contract, the maximum withdrawals for the next three years are restricted according to tables drawn up by the Government Actuary&#39s Department. The interest rate used is the redemption yield on long-dated Government bonds and the limit thereby expressed within the tables is the maximum withdrawal per £1,000 of fund at the start of the three-year period.

At the end of this and subsequent three-year periods, a new restriction is applied according to the size of the drawdown fund at that time and prevailing interest rates or long-dated gilt redemption yields. If the fund and interest rates have remained static, the member&#39s GAD limit will increase due to his reduced remaining life expectancy.

The main risks for a drawdown member are poor investment performance – especially if the level of withdrawals is high – and falling interest rates, both of which have a negative effect on the level of maximum withdrawal.

Noting that an annuity must be purchased no later than age 75, falling interest rates and a falling fund value could combine to mean that the eventual annuity purchased may be lower – perhaps significantly – than that which could have been purchased at outset when the drawdown contract was first established.

It is the interest rate risk which has unfortunately been overlooked by some advisers in the past and is now attracting particular attention from some market commentators, journalists and regulators.

If we look at an extract from the GAD tables for males (above), it can be seen that, if interest rates remain constant, the GAD limit increases substantially. However – and this is the major message behind this article – there is a significant tolerance even if interest rates fall, noticeable particularly by looking at diagonal trends (from right to left).

Take, for example, a male aged 60 at outset, with interest rates at 10 per cent. His GAD limit, broadly reflecting the annuity rate on the open market, is £119 per £1,000. If, three years later, interest rates have fallen to 9 per cent, his GAD limit would be barely changed at £117. The fall in interest rates is almost entirely counter-balanced by the increase in the member&#39s age.

A fall greater than 1 per cent would, however, lead to a fall in the GAD limit per £1,000 of fund. If, by the time the member reaches the second triennial review at age 66, interest rates have fallen from 10 to 8 per cent, the GAD limit will again show no movement at £117. Over two three-year periods, a tolerance to interest reductions of up to 2 per cent can be identified, with little fall in the GAD limit.

It is perhaps instructive to draw a straight line through the numbers noted in this paragraph and continue the line to age 75. The sequence can then be seen as follows.

The member can tolerate interest rate falls of up to 1 per cent in each three-year period with little or no loss in GAD limit per £1,000 of fund. Indeed, the tolerance increases at older ages somewhat greater than 1 per cent per period. This tolerance could also be described as cumulative in that, if interest rates do not fall for three periods, then the tolerance in the fourth period is 4 per cent. Conversely, if interest rates fall by 4 per cent in the first period, there will be an immediate reduction in the member&#39s GAD limit but this reduction will not be permanent if interest rates then remain stable. Within three more periods, the GAD limit will have returned, more or less, to its original level.

It must be remembered that a fall in the fund would affect the level of eventual annuity adversely. This is where we should start to investigate what might be called the cross-tolerances between falling interest rates and falling fund.

Continuing our example of the 60-year-old male with interest rates at 10 per cent, if interest rates remain unchanged by the time be reaches 75, his GAD limit/annuity rate would have increased from £119 per £1,000 to £167 per £1,000. Put another way, he could tolerate a fall in his fund to 119/167ths and still maintain the annuity buying power.

Thus, a fund of £100,000 would have a GAD limit at age 60 of £11,900. If the fund fell to 119/167ths of £100,000, that gives a reduction to £71,257 which, at a GAD rate of £167 per £1,000 at age 75, would give an unchanged limit/annuity rate. This means that the fund could fall in value by almost 29 per cent without reduction in the GAD limit/annuity buying power.

We have started to identify what might be termed cross-tolerances, that is, the relationship between residual fund value and annuity rates prevailing at the time of purchase.

We will continue our look at cross-tolerances next week, identifying the situation if interest rates at age 75 are higher or lower than at the outset of the drawdown contract.

A word of caution. GAD limits do not match market annuity rates exactly. Furthermore, annuity companies could reduce rates in future irrespective of any fall in interest rates – perhaps, as we talked about a few weeks ago, because of increasing life expectancy or because they find themselves with fewer annuity buyers in a poor state of health to subsidise those who are likely to live longer. Care must be taken in presenting the certainty of a final assumed annuity rate.

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