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Take an each-way bet

The citizens of Pension City, UK, are big gamblers. Even if they choose the “safest” opt ion – an index-linked annuity – they still lose out heavily if the grim reaper strikes early. However, they can make eff ective use of options that allow them to hedge their bets.

The concept of hedging is familiar to those who gamble on the stockmarkets. The prin ciple is that the investor gains some protection against volatility in markets or currency – at a price – generally by investment in futures and options.

In Pension City, there are many hedging strategies. Three particular factors affect risk – mortality, investment returns and income levels – but each can be managed with forward planning.

Annuities carry mortality risk because most of your fund could be lost if you die soon after retirement. This risk is often reduced by building in a guaranteed per iod of up to 10 years or by buying a reversionary annuity for a spouse or dependant. Both red uce the loss on early death, albeit with a corresponding reduction in the amount of annuity.

There are other options, though. Those who are in poor health, who smoke or whose job or home town suggests a lower-than-average life expect ancy can sometimes get enh anced rate annuities.

An option for those in good health is to buy life ins urance along with their annuity. If they live a long time, they get good value from their annuity. Other wise, their dependants get the payout from their life insurance.

Another option is to buy an annuity that starts relatively high – either a level annuity or an investment-linked annuity with high anticipated growth – and to reinvest some of the proceeds. This will become particularly attractive from next April, when those aged under 75 can reinvest at least £3,600 in a personal pension, with tax relief and another tax-free lump sum, irrespective of whether or not they have any earned income.

This facility, incidentally, will also be attractive to drawdown clients, who can draw the maximum income set down by the Government Actuary&#39s Depart ment and reinvest any part they do not need immediately.

Ano ther attraction is that the money reinvested in a pension should not attract inheritance tax on death as it could, for example, in an Isa.

There are also strategies for managing investment risk. With-profits annuities offer smoothing of investment ret urns to reduce the effect of short-term fluctuations in markets. They also offer some guarantees, such as that inc ome will never fall below a certain level or that it will not drop by more than a specified percentage in any year.

As with any guarantee, there is a trade-off between the level of guarantee and the prospects of significant inve stment growth. If a with-profits annuity is being recommen ded, it is important that the risk profile of the particular product is suitable for the client.

There are also investment risk management strategies for inc ome drawdown alth ough a high equity content is always needed to give a good prospect of achieving the critical yield.

It is often a good idea to put the first year&#39s income into a cash-based fund. Otherwise, if markets fall early on, income withdrawals can use up a higher-than-expected proportion of the fund, significantly increasing the future growth required.

In the later years, annuity purchase should be phased in to protect against markets being low or annuity rates particularly expensive at the end of drawdown.

Lifestyle switching into gilts is not generally a good idea with drawdown bec ause the returns will not be high enough to offset mortality drag.

Finally, there is a need to manage risks to income levels. These can come through poor investment returns but also because too much inc ome is taken early on.

With annuities, a particular risk is that inflation will eat into the value of the payments, so that the real value could reduce in the long run. A client choosing a level annuity must be made aware of this risk.

For drawdown and phased retirement, the critical yield is a helpful tool in establishing an income level. The relevant one here is the “type B critical yield”. This is based on the income selected by the client rather than the income from an annuity, which is used for the “type A critical yield”. The table below summarises the difference between the two types.

With type B yields, the ann uity rate assumed is always 1 per cent less than the drawdown yield. If the yield is relati vely high, the annuity rate ass umption may not be realistic. As a rule of thumb, you can adj ust the yield by adding 8 per cent divided by the drawdown term for every 1 per cent you think the interest rate may be out by.

For example, if the annuity is based on 7 per cent interest but you think 5 per cent would be realistic, then, for a 15-year drawdown term, you would add 8 per cent divided by 15 multiplied by two, which is about 1 per cent, to the drawdown critical yield, taking it from 8 to 9 per cent.

Another useful tool in ass essing an appropriate inc ome level is the GAD maximum inc ome. This can be used for scen ario analysis of income sus tainability. For example, what happens if the investment return ach ieved is 3 per cent below the critical yield and annuity rates fall by 1 per cent? In that situation, any income level above about 80 per cent of the current GAD maximum may be reduced by the GAD limits at the first triennial review. It is certainly wise to include this kind of consideration in discussions with clients.

As people become older, they tend to be increasingly risk-averse. A key part of the adviser&#39s job is to make sure they understand the risks and, where appropriate, to help reduce them.

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