Financially engineered advice

"Having a personalised annuity quote is a great start to rationalising and to recommending drawdown at the beginning of retirement and in subsequent annual reviews."

After you turn 60, friends who know that you work in financial services begin asking silly questions about their pensions. Whenever this happens, remember that intelligent Irishman's excellent instruction, 'Whatever you say, say nothing'. But, how to get out of this jam as elegantly as possible, when you really don't want to share your expertise for free, and risk a friendship?

Do you understand annuities?

My approach to deflecting retirement income enquires these days is to ask a simple question: 'Do you understand annuities?' I've come to see how a fresh perspective on annuities makes it a lot easier to think positively about drawdown. And all its benefits of flexibility, low regret aversion, the potential capital upside and the continuing sense of involvement and control. Some evidence suggests that we are in an environment of relatively low investment returns, at least for the short to medium term.

Bad value?

'Aren't annuities really bad value for money?' is how people reply. No, they are priced precisely by market forces, for exactly what they are. We see low rates because the only way to avert the impact of the Great Financial Crisis of 2008, and now the Covid pandemic, has been for central banks to crush interest rates. This blew up longer term returns on the fixed interest investments which underpin annuities. That gave the politicians a real problem. It made secure retirement income really expensive – for a key demographic – their baby boomers.

Sharing the risk of turning 100

The key element of the return on an annuity (over and above their bond returns) comes from risk sharing. Something drawdown does not offer. Annuities are an insurance policy against growing really, really, really old. You take out home insurance because you (and your lender) must be certain if your house burns down it will be rebuilt. And you can move back in with some clothes, a TV and some furniture. An annuity is your "extreme longevity insurance policy" and its good value for what it is, if you need it. Which ultimately most more affluent (much longer lived) people, with no DB income underpin, probably will.

Drawdown: What's the angle?

How does all this help position drawdown? Having a personalised annuity quote is a great start to rationalising and to recommending drawdown at the beginning of retirement and in subsequent annual reviews. That figure for guaranteed income brings together three critical assessments. First, someone's life expectancy given their age, health, lifestyle and location relative to other people joining the risk sharing pool. Second, the current outlook for low risk investment returns and third, how much of other people's money one can expect to share if you beat the averages and live out a longer retirement. You know exactly what income you can receive in return for your capital with absolute confidence for the rest of your life.

Pushing the envelope

So, a personalised annuity quote is the risk benchmark for rationally exploring how much more retirement income you could achieve if you are prepared to take on some additional, well controlled risks.

Longevity

Opting into drawdown means accepting the risk of funding the possibility of living a very long time, entirely from your own resources. Inside the annuity that risk is pooled, with capital transferring via the insurance company from the account of the short lived to the accounts of the survivors. So great is the benefit of this mortality credit that once your cohort starts to approach median mortality the cost of matching annuity income from drawdown with controlled uncertainty of outcome rises very sharply.

Investment returns

Entering drawdown with a portfolio of only bonds, when your withdrawals are greater than your personal annuity quote doesn't make a lot of sense. If you exceed median longevity following that strategy your chances of success in maintaining a consistent level of income will be pretty low. Which sounds like an uncontrolled risk. The opportunity with drawdown is to take some controlled exposure to equities and therefore to the possibilities of growth.

Turning to advice, supported by tech

At this point, it's plain to see that balancing these risks and opportunities takes skill and judgement. Particularly as the trend emerging is to focus on striking the right dynamic balance between secure and drawdown income at different life stages, as people's lives unfold and as their wealth and spending goes up and down. The analysis required to make these recommendations is stimulating a range of retirement planning tools. The better ones are sustained by researched actuarial input, not "working assumptions" or historical snap shots, use high quality data on life expectancies and forward-looking market projections.

Assessing the odds

A tool like Parmenion's Income Modelling Tool (IMT) provides an actuarial calculation of the probability of a retirement income plan succeeding. Using institutional capital markets analysis and longevity data from Club Vita – the longevity and risk data organisation, owned by actuarial firm Hymans Robertson – IMT will calculate for you the probability of your plan succeeding. It will also help an adviser to frame expectations for potential material increases in income from drawdown, if things get off to a good start, something an insurance policy is not designed to offer.

But what that acquaintance wanting to discuss retirement income needs to know above all – is the number of a good financial adviser.