Choosing the Right Income Paying Product in Retirement

Confused by pensions? Thanks to new freedoms there are more ways than ever before to manage your money in retirement. We take a look at the income producing options

Emma Wall 14 November, 2016 | 10:00AM
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Emma Wall: Hello, and welcome to the Morningstar series, "Ask the Expert." I'm Emma Wall and I'm joined today by Mark Polson, Principal of The Lang Cat.

Hi, Mark

Mark Polson: Hi, Emma.

Wall: So, we're here today to talk about drawdown, in particular, certain drawdown products. But if you can just start at the basics, what is drawdown and why has it suddenly become so popular?

Polson: Well, drawdown is just the way of getting money out of your pension without having to buy an annuity. It's been around for ages. It's changed many, many forums and many, many ways, many of which are horrifically tedious, far too long-winded to enter here.

But the reason it's become really popular is that over the last two or three years there have been greater freedoms extended to people who have pensions in terms of how they access their money.

So, now, you can, should you want, reap your whole pension fund out after the age of 55 and go do whatever you want to do with it. And famously the pensions administrators at times said people might go and buy Lamborghinis and things like that. I know of no one and neither do you who has gone and bought a Lamborghini with their pension fund.

But what it's done is allowed people to say, well, look, my pension fund of however much is just an asset and I'll use it in whatever way I want. The product that they use to achieve that in the industry is what we call income drawdown.

Wall: Now, in the past, before we had pension freedoms, people had to buy an annuity unless they could prove they could provide their own income over a certain amount, but the majority of people bought an annuity. Now, the problem with annuities is, rates became so incredibly low that they were no longer attractive, in part because they were linked to the 15-year gilt yield and we all know what interest rates have done over the last decade.

But one of the things that was positive about annuities is that income was income was guaranteed for life. You know exactly what you are getting year in, year out. So, the drawdown industry has responded to this, hasn't it, with some guaranteed income products, but they are not without criticism either?

Polson: Yeah, there is really no perfect answer in any of this. And the best form of pension, generally speaking, is one which is guaranteed to pay out all the time and rises with inflation and provides for your family after you die, right? And that's what people used to get from final salary pension schemes. Well, we all know what's happened to them as well.

And annuities as a product, they are opaque, they are difficult to understand. There has been some work done to show they are actually quite expensive inside, but you would never see that. But what's really killed them is economics.

Now, the rates have got very poor, particularly if you do want to build inflation proofing in or something for your spouse after your death. And that headline rate has really, really hammered annuity sales. I think at one stage they dropped by something like 80%. They have recovered slightly since then.

So, I think, it's probably right to say that in the kind of cannon of financial products that are available including bank accounts and savings accounts and so on, annuity rates still suck, but everything sucks at the moment and that's the economic environment we're in. It's great if you've got a mortgage because rates are really low and it's really bad if you need to drive income from your savings.

So, a bunch of guys mainly working in life companies have been trying to work out what they can do to try and bridge the guaranteed world of annuities and the world of income drawdown where you tend to leave your money invested in whatever form of assets you feel appropriate, might be stocks and shares, might not be, but trying to match the two up and it's not an easy thing to do. And the products have been around for a while.

These aren't new products, but they have come on quite a lot in recent years and it's entirely for those reasons to try and find something in the middle for people who aren't quite ready to all out, but really don't want to do the one and done, that's my rate for the rest of my life, kind of, decision you get with an annuity.

Wall: And these income drawdown products, which have that guaranteed income, are more expensive than normal drawdown, aren't they? But I suppose you get what you pay for and how do the rates compare to annuity rates?

Polson: Oh, dear, there is no easy answer to all of that. So, we'll do costs first. So, drawdown by itself isn't all that expensive. It depends how much you've got and where you go and what kind of forum you do and all that kind of stuff. But in the mean, you can get a product for about 0.5% a year and then you've got to add your investment costs on top and what you choose to invest and if you invest in expensive actively-managed funds, then it will be expensive or cheaper passive funds, it will be cheap.

So, you have quite a lot of control over your total charges if you're using the services unadvised or you'll normally find advisors put their charge in as well. You would expect to come out in the region of 1% to 1.2%, 1.3%, something like that for a typical drawdown portfolio and it could be quite a lot less than that.

For guaranteed products, the guarantee element of it costs anything from kind of 0.8% to 1 and a bit percent. And then you've got the product and the investment to add on, on top of that. Now, you tend to be a bit more constrained with your investment choice because the provider isn't about to give you a guarantee if you're off investing in Japanese warrants or whatever else that you want to do. So, we would tend to expect a cost of anything from about 1.7%, 1.8% up to 2% and all of those figures are before you've paid an advisor for any help that they might be giving you.

Wall: And I suppose the answer is that no one product, as you've alluded to, is the answer. It's about taking a portfolio approach to retirement, maybe having a bit of pot for money that you need in an emergency, a bit of money for sort of longer-term income and then something that perhaps you are investing in order to pass on to your loved ones after you go?

Polson: Well, if you are lucky enough to have enough to spread across all those different needs, then that's brilliant, that's exactly right. And generally speaking, a financial planner will do that. They will say, right, you want to pass on, we're going to keep that stuff invested. We may annuitize for some of it, we might buy drawdown, we might use a guaranteed product or something like that. It depends on what you want.

I think it's important to say that in most circumstances over a long period of time, maybe 20, 30, 35 years and that's not untypical now for people who spend 30, 35 years in retirement, you would expect to ride out one, two, three economic cycles during that time and with all that upsy-downsy stuff over those decades a straight up lower-cost drawdown product will generally return the most.

By the most I mean it will pay you over those 30 years including the amount that's left at the end of your life the most. So, in raw economic terms, you'll get the biggest return by using straight up drawdown and that's generally because it's the cheapest.

However, for many investors, I think, the idea that I'm going to take, let's pretend, it's 3% or 4% income from my pension pot which is a very typical amount to take if you want to try and make sure that it's going to carry on for an indefinite period, it sounds okay. 3%, 4%, that's fine. But if the markets dive off by 25%, of course your income does as well. Now, if you've got a final salary scheme and lots of secured income, you might be totally cool with that, completely fine, in which case, what we call, naked drawdown is exactly the right kind of product.

There are a good number of people for whom that's just not something they are willing to count on it, absolutely not. So, for them, what they need to do is accept that generally speaking a guaranteed product will return less over the piece over 30 years, but the journey will be a lot smoother. So, that 1% or so that you're paying for the guaranty, that guarantees do work, right? We've done a bunch of testing on these things and they are actually guarantees and that's one of the things I kind of went into being pretty cynical about was, yeah, it's a guarantee except on a Tuesday or except if a Presidential election returns something that you didn't expect.

But no, these are actually guarantees and they lock in growth. So, the provider is doing clever things behind the scenes. So, that smooths your income, but assuming markets rise over 20, 30 years you probably won't get the full effect of those rises. So, if your thing is that you can't process the idea that your income can follow a stock market style pattern and you don't want to buy an annuity, there are a class of products now that sit in the middle.

I've got to tell you a very interesting story about one provider of it, if you'll allow. Quite a lot of people have started taking their money out of final salary pension schemes. As I'm sure you'll know, transfer values have been very high of late and seem to be getting still higher and it's enough to get people to trade in the security.

One provider of guaranteed products we spoke to said that one of the major sources of business for them was people who have chosen to come out of the final salary schemes, get a big pot of money and then panicked and thought, oh, god, I've got all this money now. What am I going to do with that? I can't just put it in the stock market. I need something that feels a little bit smoother than the stock market.

And it seems remarkable to me that someone would trade in security and guarantees to get hold of their money and then think I need guarantees, but there you go, they are there. So, as with anything, if you want someone else to shoulder risk for you, you have to pay them to do it and that's what these products are trying to do.

Wall: Mark, thank you very much.

Polson: Pleasure.

Wall: This is Emma Wall for Morningstar. Thank you for watching.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

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Emma Wall  is former Senior International Editor for Morningstar