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The risk paradox

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Last week, This is money ran a story about how much money people need to have saved by the time they reach retirement and it was a staggering £600,000.

In the same article I was quoted as saying: “One of the ways you can make your pension work harder is to take on a little more risk by putting some of your pot towards an investment-linked annuity.”

This caused a number of readers to comment on how wrong they thought I was. They made the point that equities can go down as well as up and why would anybody want to take risk with their annuity?

I replied with three important advice issues. First, investment backed annuities, including with-profits annuities, are only suitable for those with
other sources of income to fall back on if the future annuity income was to fall. Second, investors must understand and be comfortable with the risks. Finally, investors should not necessarily put all their eggs in one basket and investing in a combination of guaranteed and investment linked annuities helps spread the risk.

The more I comment on investment-linked annuities, the more aware I am of what I call “the risk paradox”. Put simply, many retired investors might have to take some risk with their annuity income in order to end up in a less risky position. The keys to understanding this paradox are
longevity and inflation.

Those advising on products such as investmentlinked annuities must have followed a compliant advice process

The longer people live, the more their annuity income will be eroded by the effects of inflation. With few people investing in inflation-linked annuities because they are so expensive – the starting income is about 40 per cent lower than the level annuity – there is only two ways for annuitants to hedge against inflation.

The first is to buy a level annuity in the full knowledge that the spending power will reduce but make up the shortfall by using income and capital from other sources, perhaps including equity release. The second is to invest in an annuity which provides the potential for income growth, albeit with some risk.

Those advising on products such as investment-linked annuities must show that they have followed a compliant and TCF advice process. Advisers will need to demonstrate that they have fully explained how these annuities work and have explained the risks in a way the customer understands. They must know a client’s retirement objectives and personal circumstances and they must ensure that the recommendation is
fully understood and suitable.

The good news is this is not as hard as it seems if advisers invest time in understanding these key issues in what I believe has become one of the most important areas of retirement income advice.

Billy Burrows, Director, The Retirement Strategy

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