In this and my next two art-icles, I will identify and discuss certain aspects of the risks associated with pension drawdown contracts.
In particular, I will concentrate on the level to which those risks can be tolerated without the client being financially worse off than if he or she had elected to take a conventional annuity at the outset.
By way of a simple reminder of the nature of pension drawdown, these contracts offer the ability for a retiree to draw an annual income from an investment fund. The most obvious point to note is that the client retains control over the fund, the size of which determines the level of withdrawals which may be made.
Pension drawdown is usually perceived as a much higher-risk alternative to a conventional annuity, under which the annuity provider guarantees the income for the remainder of the annuitant's life and possibly the remainder of his nominated dependant's life if longer.
On starting a drawdown contract, the maximum withdrawals for the next three years are restricted according to tables drawn up by the Government Actuary's Department. Different tables exist for males and females and for protected rights and non-protected rights. The more widely used non-protected rights tables broadly represent a competitive single-life level annuity at a given market interest rate.
These GAD tables are constructed for a wide range of prevailing market interest rates at the outset of the drawdown strategy. The interest rate used is the redemption yield on long-dated Government bonds and the limit expressed within the GAD 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 calculated and applied according to the size of the drawdown fund at that time and prevailing interest rates (long-dated gilt redemption yields). If the fund and interest rates have remained static over the three-year period, the member's GAD limit will increase due to his older age and reduced remaining life expectancy.
The main risks for a drawdown member are poor investment performance (especially if the level of withdrawals is high), along with falling interest rates and increasing life expectancy (which will, of course, adversely affect the level of annuity which can be purchased no later than age 75). All these have a negative effect on the level of maximum withdrawal.
Indeed, noting that an annuity must be purchased no later than age 75, falling annuity rates and/or a falling fund value could combine to mean that the eventual annuity purchased may be lower – perhaps significantly lower – than that which could have been purchased at outset.
Out of these three main risks, 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.
In this article, I will start by examining the nature and extent of the interest rate risk, then look at the investment risk. Finally, I will combine these risks in conjunction with the trend of increasing life expectancy. Throughout, I will look at what might be termed the tolerances to adverse movements in either or both these risk factors.
As regards tolerance to interest rate movements, if we look at an extract from GAD tables for male non-protected rights (top right) you might be able to identify certain interesting trends.
From this extract (which, to take poetic licence, I am assuming broadly represents market annuity rates at each level of underlying interest rate) it can be seen very clearly that if interest rates remain constant, then the GAD limit increases significantly between ages 60 and 75, for example.
However, more interestingly and importantly, 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 of pension fund.
If, three years later, interest rates have fallen to 9 per cent, his GAD limit of £117 per £1,000 will barely be changed. The fall in interest rates is almost entirely counterbalanced by the increase in the drawdown member's age.
A fall greater than 1 per cent during this period would, however, lead to a fall in the GAD limit per £1,000 of pension fund.
By the time the member reaches the second triennial review at age 66, if interest rates have fallen from 10 per cent to 8 per cent, the GAD limit will again show no movement at £117.
Thus, 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 although, of course, there remains the investment risk.
It is instructive to draw a straight line through the numbers from 10 per cent at age 60 through 8 per cent at age 66, then continue this diagonal line (representing a 1 per cent fall in interest rates over each three-year period) to age 75. A sequence can then be noted (above).
It can be seen that 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 in each period.
This tolerance could also be described as cumulative, in that, if interest rates do not fall for three periods, the tolerance in the fourth period is then 4 per cent. Conversely, if interest rates fall by 4 per cent in the first period, there will be an initial reduction in the member's GAD limit for the first triennial review 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 – a move towards the diagonal line trend.
These diagonal line trends can be identified for both males and females – although they are not quite so marked for females as 1 per cent in each three-year period – and at all ages and interest rates.
Thus, from any interest rate starting point, the tolerance to interest rate falls is 1 per cent in every three-year period up to the time when an annuity must be purchased. To use a common example, this means that a 60-year-old drawdown member can tolerate a 5 per cent fall in interest rates by the time he reaches age 75. This is particularly interesting at a time when interest rates are lower than 5 per cent.
In my next article, I will develop this concept of tolerances using the same principles to illustrate how the risk of poor investment performance may also be tolerated up to a particular level.