Solving the retirement income puzzle… apply Occam’s razor?

'The principle for solving problems that states, the simplest solutions are often the right ones'

Planning retirement income can be complex, principally as every retiree's needs are different. This often means having to make a compromise somewhere along the line when constructing a retirement income solution, in part because we still have broadly the same retirement products to choose from that we have had for the last 20 years.

And yet what people expect from retirement has moved on. In spite of this, retirees are seemingly continuing to put all of their retirement eggs in one product basket. Either opting for drawdown, or an annuity.

New research from actuarial firm Milliman has found that there is a case for considering a blend of products. This provides (in many instances) better long-term outcomes for retirement income provision and death benefits.

If retirees are looking for a mix of flexibility and guarantees, is it the case that the simplest solution is the right one?

Resistance to change?

'Blending' seems to be something that everyone thinks is a good idea, but there doesn't seem to be much evidence of it happening.

This is understandable, the preference of today's retiree seems to be for retaining total access rather than feeling 'locked in'. And we see this reflected in advisers' current business models. Assets under management through platforms are where many adviser firms do business now.

However, is this approach future proofed? Is there a hidden danger of failure in the future due to the need to satisfy today's commercial requirements? This doesn't necessarily mean that advisers should change the way they apply their fees. It's more a case of making a link between the value that fees will generate, and the risk that a retiree's pension funds could deplete over time. If a retiree's funds run out as they are spent down, so does the adviser's income stream.

Are we sleepwalking into future problems?

Drawdown purchases are now outnumbering annuities by nearly 3 to 11. Those individuals have to accept that they shoulder all of the risks.

This not only includes longevity and investment risks, but more subtle issues that need attention, such as whether they have adapted their portfolio criteria. The demands of decumulation are very different to the accumulation phase.

Delivering a sustainable rate of drawdown income might currently seem like a walk in the park, given that investors have experienced a good run of stock market returns recently. But what happens when there is a market correction? The global political and economic disruptors at play, such as potentially harmful global tariffs, diminishing QE, and the sensitivity of interest rate changes are all creating a perfect investment storm.

The fallback position for drawdown portfolios is to hold fixed interest and corporate bond type funds in order to diversify. However, yields are not what they used to be, and these funds are not immune to volatility either.

If the methods of the past cannot be relied upon, where do you go?

The search for alternatives

There are an increasing number of research papers that raise doubts about the validity of trying to retain fund growth and provide sustainable income solely from invested sources. And they go further to suggest a blend of investment and annuity has real merit in achieving many retirees' goals.

Morningstar – their paper 'Safe withdrawal rates for retirees in the United Kingdom'2 finally updated the 4% 'Bengen' rule: "…these findings suggest that financial advisers and retirees in the United Kingdom should use lower initial safe withdrawal rates…2.5% or 3.0% and not the previous 4.0%".

Institute and Faculty of Actuaries – The March 2018 paper 'Can we help consumers avoid running out of money in retirement?'3 also backed up a lower safe withdrawal rate if relying on investment only: "Consumers can reduce the risk of a low income due to living longer than expected or adverse market conditions by combining drawdown with annuities".

They also investigated combining drawdown with an annuity: "Our modelling compared consumers who either bought just a drawdown product or just an annuity with different strategies that combine both drawdown and annuitisation. We found that a combination of products is beneficial".

Milliman – 'Annuities reinvented'4 stochastically models the question of what happens if you replace bonds with an annuity:

  • "Our analysis indicates that, for longer periods of retirement, a combination of an annuity income and drawing down from an equity investment fund could lead to a higher likelihood of achieving a person's target income and a higher death benefit compared to drawing down from a mixed bond and equity investment fund".

This can be been seen from the following chart that plots different degrees of health for annuity rates, and compares against bonds over a 35-year period.

Likelihood of a 65 year old meeting target income of £4,000 a year (increasing with inflation). Fund: 55% Equity, 5% Cash, 40% Bond or Annuity

 55% Equity, 5% Cash, 40% Bond or Annuity

Source: Milliman – Annuities Reinvented 2018

Milliman also considered the impact on death benefits to see what the difference would be:

  • "Our analysis indicates that, for longer periods of retirement, a combination of an annuity income and drawing down from an equity investment fund could lead to a higher likelihood of achieving … a higher death benefit compared to drawing down from a mixed bond and equity investment fund".

Average death benefits for 65 year old target income of £4,000 a year (increasing with inflation). Fund: 55%, 5% Cash, 40% Bond or Annuity

 55% Equity, 5% Cash, 40% Bond or Annuity

Source: Milliman – Annuities Reinvented 2018

This supports the idea that an annuity underpin can in many instances unshackle the equity fund to go for growth, providing a better outcome for retirees.

Conclusion

There are many commentators bemoaning the lack of new products for today's retirement needs. New products will be forthcoming eventually, however the lack of progress is not surprising when you consider the enormous costs involved to bring a new product to market.

In the meantime, the innovation is already right in front of us. It is creating solutions built from the component parts of the product frameworks we already have at our disposal. Investment for flexibility and guaranteed products for essential income.

The simplest solutions are often the best, however, building and maintaining a good retirement solution isn't easy, and requires skills and knowledge that makes advisers invaluable.

  1. FCA Monthly Data Bulletin – September 2018
  2. Morningstar – Safe withdrawal rates for retirees in the United Kingdom 2016
  3. Institute and Faculty of Actuaries – Can we help consumers avoid running out of money in retirement? 2018
  4. Milliman – Annuities Reinvented 2018