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Variable values

In the third part of a four-part series surveying the retirement market, Annie Shaw reports on investing in a low-interest-rate environment and the attraction of drawdown and variable annuity guaranteed income products

Pension savers coming up to retirement must have wondered what hit them over the past 18 months. Stockmarket falls wiped out a quarter to a third of assets held in equities, some cash turned out not really to be “cash” while any holding that really was in cash saw returns fall as interest rates went through the floor.

The risks associated with delaying taking an annuity could not have been demonstrated more clearly, not least for those in drawdown.
Yet, far from putting investors off drawdown, some advisers think that now could be the ideal time to opt for it.

Informed Choice managing director Martin Bamford says: “Now that pension fund values have recovered many of their equity-related losses and annuity rates look reasonably good, unsecured pension will look less attractive for many people.

“However, the attraction of unsecured pension is not simply limited to income levels. Many investors choose this option for the enhanced death benefits or the ability to access tax-free cash without taking a taxable income. As a long-term strategy for investors with other assets or sources of income in retirement and for those with larger pension funds, unsecured pension will remain a viable alternative to annuity purchase.”

Drawdown has grown steadily since the option became available in the 1990s. Take-up rates took a knock after the internet bubble burst in 2002, and clients and advisers started to wake up once more to the downside risks but by 2006, drawdown had taken off again, reaching 21 per cent of the retirement income market.

In the same year, the FSA launched a consumer campaign to warn investors against the dangers of drawdown, particularly for those with small pension pots.

Despite the shocks of the last couple of years – and the Financial Ombudsman Service is reporting increasing numbers of complaints about drawdown – the market looks set to take off again. Hargreaves Lansdown says in the past six months, enquiries about drawdown are up 142 per cent on the previous year.

So are there still sound arguments in favour of drawdown?

Dennehy Weller managing director Brian Dennehy certainly thinks so. “We actually used to do very few drawdown cases because of the inherent risks,” he says. “When we did get people coming to us determined to do drawdown, we explained to them how their fund could fall in value. When we asked them, how would you feel, financially and mentally, if it got this bad, most of our clients decided against it. You have to remember these people were looking at retirement very likely without other income. They men- tally often did not want risk.”

The difference now, he says, is many people still invested heavily in equities, particularly younger retirees who have taken the hit on their funds, are looking at recovery. Older investors with a good adviser should have been reducing their risk over the five or more years up to retirement but many clients in company schemes without an adviser until now may not have done so.

Younger savers who are thinking of accessing their pension funds as soon as they can and older savers who can afford to choose the optimum time for annuitising, will there- fore be looking at drawdown.

Dennehy says: “The situation is completely the opposite from a year or two ago. The risks associated with drawdown in order to get extra income used not to be worth taking compared with what could be achieved from an annuity. Now, however, we feel that since capital values have fallen, this pushes yields up and investment in equity income funds can potentially achieve a much higher level of income than an annuity can give.

“We believe equity income funds have hit a sweet spot and that careful managers can certainly achieve better than the annuity rate. For instance, the Newton higher-income fund is currently yielding in excess of 7 per cent gross.

“We are quite excited about next year as companies seek to grow their dividends.”

But such flexibility does not come without a cost. Dennehy warns that drawdown is an “advice-heavy” product and he underlines that investors remain exposed to full investment risk. “Yes, drawdown is risky but there is no reward without some element of risk,” he says. “Any member of the public taking this route needs to have an adviser that nurses that product. One of the key decisions is just when to annuitise. The adviser needs to keep an eye not just on investment issues but also on annuity rates, the client’s state of health – and that of their spouse – and state benefits.”

One way to minimise investment risk without committing to a conventional annuity is through a third-way variable annuity product, which allows the fund to remain invested but guarantees a certain level of income.

Variable annuities are popular in the US and Japan, but advisers have been slow to promote them in the UK because of their complexity.

owever, one hoping that this will change is US giant MetLife which is stepping up its UK operations.

Dominic Grinstead, managing director of MetLife UK, says: “The whole concept of variable annuities is it allows people access to equities but protects them from the worst that can happen. They guarantee an income for life.”

But there are some concerns about the cost of that guarantee. Tamsin Abbey, head of Deloitte’s variable annuity product group, says:

Guaranteed annuity rates can look poor in a stable, low-interest- rate environment.”

Yet variable annuities can offer a range of guarantees, including guaranteed minimums for income benefit, death benefit, accumulation benefit and withdrawal benefit.

These guarantees are achieved by both static and dynamic hedging and sometimes by reinsurance. How the guarantees work and where there is counterparty risk is not always transparent, however, and many advisers shy away from recommending the products for these reasons.

Abbey says: “IFAs seem to have concerns about value for money of the charges for guarantees as well as general concerns about a new product. They are understandably concerned about potential misselling.”

Grinstead says the concerns over charging may have been relevant several years ago but many products are now very competitive.

He says: “The combination we have is that we marry up packaged funds and guarantees together and in many cases we find that package is less than a multi-manager and fund of fund approach. We can offer an all- in product charge, including the guarantee and fund management, for less than 100 basis points. I would say people were looking at what the costs were a couple of years ago but in many cases now they are pretty competitive.”

Martin Bamford thinks variable annuities will be slow to catch on in the UK. He says: “There is a lot of hype about the potential for the third-way annuity market in the UK but I believe it is unlikely ever to become as popular as it did in the US.

“British investors typically want one of two things in retirement – absolute certainty of income for life or the ability to stay invested and maintain flexibility of income levels. Existing conventional annuities and the unsecured pension option already cater for these needs adequately.

“Third-way annuities attempt to deliver the best of both worlds, something that must come with extra cost, complexity and risk. It remains an infant market in the UK, with relatively niche products which are difficult to compare because they present different features.”

But Grinstead says: “It is a growing market. There will be something like 500,000 people a year retiring ear and taking benefits from DC schemes over the next 10 years, so it is a huge market. We think there is space for lots of innovation in the marketplace. Watson Wyatt predicts that around 15 per cent of the market will go to this type of product set. Fifteen per cent of 500,000 is a pretty big number, around 75,000 policies a year. It is nowhere near that at the moment but we do think it will be one of the fastest growing product areas in the financial services market over the next few years.”

Brian Dennehy says: “The way that variable annuities minimise risk means that they are limiting scope for reward, which means they could actually underperform traditional annuities.

“The cost and complexity of the structured products that underlie them make us uncomfortable and are a real worry for advisers. If we worry, clients should worry.”

But Aegon Scottish Equitable International managing director David Healy says: “There is a substantial market in the UK of customers who require the security of a guaranteed minimum income for life but also want the opportunity for that income to increase over time by participating in potential equity growth. Many of these people are also looking for a flexible product that allows them access to their capital. Variable annuities are the only product type in the market to offer all of this.”

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