The realisation that there is a significant upside to including fixed interest guaranteed assets within drawdown should encourage platforms to act swiftly to meet demand, writes Stephen Lowe...
Blending takes the best qualities from different styles of coffee to create a smoother drink. Combining different coffees this way adds balance and complexity. It also highlights the best elements of each component .
This is analogous in retirement planning to the relationship between annuities and drawdown. They are polar opposites in so many ways, but blended together they create a powerful synergy. They deliver what many retirees consider the ‘holy grail' of security with flexibility.
Security is a key benefit of an annuity. Providing reassurance and comfort; helping people to sleep at night. It satisfies our basic needs. The primal urge to feel safe and secure, to have enough food, drink, shelter, clothing, and warmth.
But this is the gift that keeps on giving. While comfort and security are invaluable, a guaranteed lifetime income can provide much more. There have been a succession of independent studies over the last few years, that have effectively redefined the role of an annuity. Peace of mind may be a nebulous concept, but there's nothing indistinct about the role of guaranteed lifetime income as an asset class. Consider the facts:
- The Institute and Faculty of Actuaries modelled a range of strategies involving drawdown and annuitisation and concluded that by adopting an integrated strategy ‘consumers can potentially generate a larger overall income from their pension pot'.
- Global actuarial firm, Milliman, explored displacing the bond element of a drawdown portfolio with an annuity and found that ‘for longer periods of retirement annuitising part of the retirement pot resulted in a higher likelihood of maintaining a target annual income and a higher average death benefit'.
- More recently, Abraham Okusanya, Timeline CEO, substituted half of the bond element in a 60/40 drawdown portfolio for an annuity, resulting in a 60/20/20 split. Using 120 years of capital market data the results showed that introducing the annuity element boosted the fund value over the long term.
A blended solution - combining a degree of annuitisation into a drawdown portfolio - reduces volatility, improves the sustainability of income and often increases the overall value on death over the long term. So how and why does it work?
Worked example
Consider a 65-year-old with a £500,000 fund planning to withdraw £20,000 income each year. If they buy a single life level annuity for £200,000 this would currently provide over £14,000. That means they only have to withdraw less than 2% from the remaining £300,000 drawdown fund, which can remain 100% invested in equities. This has two key benefits. Firstly, because the amount disinvested each year from the equity portfolio is low, exposure to sequencing risk is limited. Secondly, the equity element can grow faster for the same reason: There is little disinvestment of the equity portfolio.
Of course, some advisers will use cash pots to provide income. This is a sensible precaution to protect against sequencing risk, but overall it is sub-optimal. During most periods, markets are rising so money left in cash or low-risk assets is a drain on performance.
It's also worth asking whether sacrificing part of the bond allocation to buy an annuity makes sense. Bonds are traditionally considered to be negatively correlated with equities, but this inverse relationship has recently been questioned. Earlier this year both equities and bonds fell in value.
Nevertheless, over the last 20 years, there has been a negative correlation between stocks and bonds, but look further back and the stock/bond correlation was positive for almost all of the preceding 250 years. What's more, recent analysis of the US bond market concluded that ‘Statistically, stock and bond returns show at most a weak correlation'.
In contrast, an annuity will always pay a fixed income irrespective of whatever happens in the market. This isn't to suggest that there isn't a place for bonds in a portfolio. The core principle of diversification would argue for some exposure to bonds and the Timeline analysis suggests that splitting the bond element of a 60/40 equity/bond portfolio to a 60/20/20 equity/bond/annuity portfolio will still deliver a better long-term outcome, so it's not necessary to forego bonds completely to deliver better outcomes.
The important point to remember is that the equity holding should not be reduced.
Another issue is the availability of annuity-type assets on platforms. It's possible to buy an annuity off platform, but the income would be taxable. New fixed interest guaranteed asset classes that can sit on platforms are emerging. Advisers need to lobby investment platforms to accommodate this type of asset.
The realisation that there is a significant upside to including fixed interest guaranteed assets within drawdown should encourage platforms to act swiftly to meet demand.
Stephen Lowe is group communications director at Just Group
