In 2015 the introduction of ‘pension freedoms’ was a game changer for the retirement income market, moving existing pension savings from a source of income in retirement to a financial planning vehicle, says Keith Richards, chief executive officer at the Personal Finance Society.
Prior to its implementation approximately 75% of individuals converting their pension fund to an income stream entered into an annuity contract, while income drawdown was a much smaller part of the market.
But since the introduction of pension freedoms the situation has reversed, with around 75% of people now opting for drawdown.
At the same time, we are starting to see a change in attitude to traditional retirement, with many people now transitioning into retirement (rather than it being marked by a distinct point in time) and looking at their overall assets, including residential property, savings and pensions, to fund their changing income needs at different points during later life.
While pension freedoms have provided flexibility, such as that inherent in drawdown, it is still the main aim of most people that their pension provides them with an income that lasts through retirement. Indeed, this is one of the reasons the regulator continues to look closely at the retirement income market.
The following, taken from the Personal Finance Society paper A practical guide to advised pension income drawdown, is designed to provide advisers with further commentary and clarification on good practice, given the increased numbers of retirees selecting income drawdown as their preferred retirement strategy.
This article covers points 1-9. Part 2 will cover points 10-17.
1. Understanding the client’s overall financial position
Income drawdown isn’t really a product – it’s more a strategy for withdrawing retirement savings from a tax wrapper.
Advice on income drawdown therefore requires broad context, specifically the wider financial circumstances and needs of clients, given in almost all cases it involves a trade-off between risk and reward as well as tax mitigation decisions.
If your client has other sources of income, lifetime savings or realisable assets, including residential property, these should be considered and, in many cases, might offer up a more tax-efficient route compared to withdrawing income from a pension.
2. Ascertaining the client’s starting position
As well as understanding a client’s overall financial position, a bespoke approach stemming from establishing a client’s starting position is often critical in ensuring a good consumer outcome.
For example, some clients are looking for deferred drawdown, wanting to take their tax-free cash with a view to buying another pension product later down the line.
Other clients are looking to take the maximum tax-efficient income from their pension to bridge the gap until their state retirement pension and/or occupational pensions kick in.
3. Assessing all options
The Taxation of Pensions Act 2014 (‘pension freedoms’) allows an individual to take as much or as little as they like from their money purchase arrangements on reaching the normal minimum pension age (or earlier in special circumstances).
While scheme rules do not have to offer all the flexible options allowable, all available options, including a transfer to an alternative arrangement, should be considered to arrive at the most suitable client outcome.
Advisers need to demonstrate they have carried out sufficiently broad research on the products available in the market, as well as checking that the product they have selected does what it says on the tin. This should include commentary on why the existing provider (if applicable) is not being considered or chosen.
Advice on drawdown itself is increasingly not a binary choice for many in respect of retirement income products, with good practice involving an assessment of the suitability of a full spectrum of retirement income solutions, including phased drawdown and blended or hybrid solutions, so that current and known/unknown future income needs can be best accommodated.
Drawdown should also be benchmarked against annuities and, where appropriate, enhanced annuities.
4. Considering all the risks
Drawdown is almost always a balancing act between mitigating risk, receiving returns and retaining some flexibility.
A successful drawdown strategy involves the ongoing and effective management of any number of client risks following the establishment of attitude to risk and capacity for loss.
Essentially this is about helping clients understand the greater risks associated with drawing down retirement portfolios, compared with the accumulation stage, including:
- Sequence of returns risk (also known as reverse pound cost averaging) – where withdrawals during a market downturn can lead to a rapid reduction in the value of a fund.
- Volatility drag – the risk inherent where a portfolio falls in value and then needs to work harder to go back to its initial value.
- Inflation risk – helping the client appreciate how long their portfolio might need to last and a considered view on the impact of inflation (for example, 5% inflation reduces real income by two-thirds over a 20-year period). Even relatively benign rates of inflation can have a huge financial impact over increasing years in later life.
- Longevity risk – an assessment of average life expectancy and helping clients understand the probability of living beyond this.
In addition to the above, specific warnings should be given to clients including:
- The capital value of the fund may be eroded;
- The investment returns may be less than those shown on the illustrations;
- Annuity rates may be better or worse in the future;
- High levels of income may not be sustainable.
5. Clarifying all the charges
In the FCA’s 2017 Retirement Outcome Review, when commenting on non-advised drawdown, the regulator stated: “Drawdown charges can be complex, opaque and hard to compare…”
It’s particularly important that advisers follow good practice in respect of adviser charging and associated disclosure for drawdown, given the added complexity around such things as charges for drawing an income, drawdown set up charges, platform custody charges etc.
6. Establishing an optimal investment strategy
Advisers should consider the need for a different investment approach for clients in the accumulation and decumulation stage.
In adverse market environments, volatility combined with withdrawals can result in significant falls in portfolio value, so the effective delivery of low-volatility growth through a regularly reviewed investment strategy is a crucial objective for most drawdown clients.
7. Establishing a prudent withdrawal rate
Linked to the above, advisers should have a robust framework in place when it comes to advising clients on what commentators often refer to as a safe withdrawal rate (SWR).
Drawdown is, however, not without risk. As such, good practice should also extend to the use of more accurate words such as ‘prudent’ or ‘reasonable’ withdrawal rates.
Of course, any rule of thumb needs to be adapted to take into account individual client circumstances as well as external factors such as inflation.
Where a withdrawal rate is established to provide a sustainable income, the adviser should take account of the key aspects of the FCA policy statement PS18/6 – Advising on pension transfers, including current transfer value analysis (TVA) and the subsequent application of the appropriate pension transfer analysis framework (effective 1/10/18).
8. Minimising tax
One of the key ways advisers can demonstrate value (and increase sustainability of income) is in respect of limiting tax on withdrawals.
Unless a pension provider holds an up-to-date tax code, lump-sum withdrawals from a pension plan are subject to income tax under the emergency rate basis. This results in an overpayment of tax for a significant majority of individuals making their first withdrawal from their pension.
While this overpaid tax may be reclaimed during the tax year using one of the new HMRC forms specifically designed for this purpose, consideration of strategies to avoid emergency tax – including utilising phased income withdrawal when a large tax-free cash amount is not required – is good practice, where appropriate.
In addition, advisers should always raise the issue and assess the impact of the lifetime allowance (LTA), both on withdrawals and at age 75 on remaining benefits.
Account should be taken of the existence of any protection from the LTA charge in respect of the value of benefits built up (and future benefits that may accrue) in excess of the LTA.
9. Consideration of other opportunities
Where appropriate, advisers should consider other planning opportunities related to drawdown, including, for example, the use of spousal bypass trusts, the recycling of income and the use of excess income to fund pension contributions (eg, for children or spouse).
FCA acts to stop drawdown retirees losing out
Source: The Personal Finance Society’s A practical guide to advised pension income drawdown – September 2018