Allocated pensions have become a relatively standard feature of many investors’ retirement plans. Their simplicity combined with tax and social security concessions have driven a large part of this acceptance.
But, over the past year or so, some of the quirks in the design and operational structure of allocated pension products have become apparent to many advisers and their clients.
One, which is receiving coverage at present, is the difficulty investors face with the prescribed draw down rates in a low-return environment. How likely is it that these investors will outlive their savings?
For those investors who commenced an allocated pension between 1995 and 2000, the current environment may not pose too much of a problem. These investors have invested over a period where most returns have been well above the minimum draw down rates. This means that their account balance should have increased overall.
This is a classic demonstration of the ‘standard’ increase in value in the early years of an allocated pension assumed by many financial plans. These plans assume that this excess in the early years will allow higher draw down rates in later years or will allow the capital base to last longer enabling investors to ride-out periods of lower or negative returns.
But, what about those investors who commenced their allocated pension in falling or low return markets, for example, over the past couple of years?
These investors are forced to draw down income amounts that will be in excess of their underlying investment return. So even when they receive positive returns, they may never be able to rebuild their account balance to that assumed by their original financial plan. These clients will therefore have to live with a lower level of income, potentially for the rest of their lives.
There are a number of possible solutions.
Firstly, the minimum draw down rates could be lowered. However, the lowering of minimums in itself does not solve the problem, because it may simply drive retirees to accept a lower income and therefore a lower standard of living.
Another popular solution has been to ensure that two to three years of income requirements have been retained in cash and so allow the rest of the portfolio to ride out market fluctuations over that period.
However, two to three years may not be a sufficient period of time to recover some investment losses. So what happens once the cash has been exhausted? In effect, investors must then convert paper losses to real losses. This means that more frequent attention needs to be paid to the asset allocation of allocated pension accounts to ensure there is always sufficient cash to meet the next two to three years of income payments.
Another solution would be to ensure that all of a retiree’s assets are not at the mercy of investment markets. This may involve using short-term annuities, putting a percentage of assets into complying pensions/ annuities or alternatively it may also involve the development of hybrid products combining the features of allocated pensions with the guarantees of an annuity.
So while there have been calls to review the structure of allocated pensions, these issues are relatively minor. It is far more important for advisers to structure their advice to protect their clients’ future income.
Kieren Dell and StuartMilne are principals ofPraxis Partners.
