So what can we learn from these two simple examples?
In the UK, many advisers and their clients have been tempted to take the same income from a drawdown as they could have taken from an annuity. As the examples show, these relatively high rates of income withdrawals expose the drawdown pot to significant levels of risk if investment returns get off to a bad start. Those wanting a high income, especially those who qualify for an enhanced annuity, may be better advised to consider an annuity.
A better approach is to work out the sustainable level of income. There has been a lot of academic research into this and it is generally agreed that an income between 3 per cent and 4 per cent of the fund value (increasing with inflation) should be sustainable over the longer term without significant risk of running out of income.
One of the problems with the matching annuity income strategy is that we are not comparing like with like. Annuity payments include an element of repayment of capital as well as interest and some mortality cross-subsidy premium. A good way to explain the benefit of mortality cross-subsidy is to think of it as an ‘invisible force’ that gives annuities an income advantage over drawdown.
Advisers who have been involved with drawdown will know only too well the importance of implementing the appropriate investment strategy. Although there are many different strategies, successful drawdown plans all have one thing in common, and that is some mechanism for reducing the exposure to sequence of returns risk.
There are many different strategies for reducing this risk, and professional advisers should make sure their own drawdown proposition has a clearly defined approach to investing drawdown funds.
Future expectations
Experience shows that the clients who complain the least when things go wrong are normally the ones who understand the risks they are taking and have a reasonable expectation of future investment returns. Therefore, it is vitally important that all the risks are explained and understood at the outset. In short, clients need to understand that although drawdown may appear to be a better bet than an annuity, it is not always the case.
People retiring at the moment are between a rock and a hard place: low interest rates and volatile stock markets. This means that the binary choice between a single annuity and a single drawdown plan is a difficult decision in the current economic climate. It is probably true to say the ‘annuity or drawdown’ decision is one of the most difficult in retirement planning.
Often, there is a strong case for annuities as well as a strong case for drawdown, and this can easily be translated into a strong case for a combination. The new combination plans make arranging a combination of options much easier.
