Stephen Hyams shares a proposal from the Pension Decumulation Pathway Working Party that could help those with defined contribution pensions to achieve better outcomes
A successful defined contribution (DC) pension decumulation strategy should begin with an evaluation of one’s objectives. These can be broadly categorised into: generation of a lifetime income; the flexibility to draw money when you want; and the ability to leave some money as a legacy. These objectives are in competition, since targeting one restricts the ability to meet the others.
Suitable decumulation products are then needed to meet those objectives. In the UK, there are currently two main options:
- The guaranteed annuity. This provides a secure lifetime income, but is unpopular because it is inflexible, and commonly regarded as expensive and poor value in the event of early death.
- Flexi-access drawdown. This provides flexible access and good value on early death, but is not well suited to provide a lifetime income because it does not adequately manage longevity risk (the risk of outliving the available monies in the DC pot) and requires complex and time-consuming ongoing management.
To help implement a successful decumulation strategy, the IFoA’s Pension Decumulation Pathways Working Party proposes the introduction of a decumulation pathway (DP), in which the DC pot is split into two components:
- The ‘pension fund’ to generate a lifetime income
- The ‘flexible fund’ to provide flexible access, with the option to leave some money for legacy purposes.
Consumers would choose the proportions allocated to each fund according to the importance they attach to different objectives. Suitable products would then be offered for each fund. There might be the option to switch monies between the funds over time, rather than it being a one-off decision.
Figure 1 shows how a consumer might transition into a DP. After taking any tax-free cash, the balance is initially transferred into drawdown. Ad hoc amounts may be withdrawn over time, but once a regular lifetime income is required, a DP can be offered.
Suitable products for a DP are drawdown for the flexible fund and an annuity for the pension fund. However, alternatives are needed for the pension fund to cater for those who do not want to buy an annuity.
“We propose the introduction of a decumulation pathway, in which the defined contribution pot is split into two components”
The cost of an annuity reflects the need to service the guarantee, which requires the insurer to adopt a very cautious investment strategy and maintain contingency reserves. A product without a guarantee on the level of income has greater investment freedom and much-reduced reserving requirements, with the potential to achieve a significantly higher (but variable) income than the annuity for a given purchase price. It also needs to manage longevity risk.
Two products that meet these criteria are:
- Collective defined contribution (CDC) schemes. These are trust-based arrangements in which members’ assets are pooled and longevity risk is thereby automatically pooled between members. CDC is new in the UK, and is expected to become usable as a mainstream decumulation option in due course.
- A product seen in various forms around the world, which we refer to as the pooled pension fund, in which individual DC pots are retained and longevity risk is pooled between participants or insured on a rolling basis. Examples of this can be found in the Netherlands and Canada, and there is growing interest in other countries.
Managing longevity risk
The importance of managing longevity risk can be seen in Figure 2 (below), which shows the probability distribution of age at death for someone currently aged 67. The initial DC pot needed to provide a specified lifetime income is highly uncertain, in view of the wide spread of potential pay-out periods until death.
One solution is to insure the longevity risk, which is what happens with an annuity. An alternative is a mutual arrangement in which longevity risk is pooled between participants, so that those who live relatively long are subsidised by those who die earlier. This happens automatically with CDC.
For the pooled pension fund, where individual DC pots are retained, an explicit mechanism is required whereby DC monies of deceased participants are transferred into a ‘longevity pool’ and reallocated to surviving members as ‘longevity credits’. In principle, this aims to be actuarially neutral, or ‘fair’, in that nobody expects to gain or lose; however, practical considerations are likely to conflict with this intention. An alternative is an insured arrangement where, for each period, the insurer pays pre-agreed longevity credits in return for receiving the DC pots of deceased members.
Any form of longevity risk management has two consequences. Firstly, there is a cross-subsidy between those who die early and those who survive longer; this is most clearly demonstrated in the pooled pension fund, where DC pots are forfeited on death.
“The introduction of decumulation pathways could provide significant assistance by encouraging people to think about their objectives”
There is also a reduction in the ability to exercise some ongoing management of the arrangement, such as to vary the investment strategy or the level of income taken. An annuity and CDC provide no such flexibility. With the pooled pension fund, a degree of choice could be offered, but only where pre-agreed and to a limited extent, in order to protect the pool from selection – for example, to prevent someone in poor health from withdrawing their DC pot to prevent it from being lost on their death.
We have designed a ‘standard’ DP, aimed at the typical consumer, which might be offered as a default solution. It has a modest (10%) allocation to the flexible fund, with the bulk being assigned to the pension fund and having the following features:
- Withdrawal strategy: Automated, with the affordable income assessed at least annually using a single-life index-linked annuity rate. This is notional in that an annuity is not actually purchased and the annuity rate uses a discount rate that reflects a best estimate of the future investment return. This approach ensures that the income lasts a full lifetime, and aims to increase each year in line with inflation.
- Longevity risk management: Assets are transferred from drawdown into a pooled pension fund over a five-year period from age 75. The phased transfer is to avoid a step reduction in death benefit and in flexibility.
- Investment strategy: One that would typically be categorised as ‘medium risk’, with a 50% equity allocation.
In practice, the standard design would be tailored to reflect the needs of the target consumer group. There could also be the option to vary some of the standard features to suit personal choice, such as the flexible fund allocation or investment strategy, or the provision of a surviving dependant’s pension.
We devised some metrics to measure the success of the standard DP and evaluate the impact of varying some of its features. Figure 3 is an example of our stochastic modelling results, showing the distribution of the 30-year average inflation-adjusted income for the standard DP. The median average income is 4.1% of the initial investment, slightly above the initial income of 4.0%, while the inter-quartile range is 3.3% to 5.1%.
By comparison, the income from an index-linked annuity is a constant 3.0%, so the median average income from the standard DP is 37% higher, while overall the standard DP has an 82% chance of providing a higher average income than the annuity.
If the pension fund instead remains in drawdown (with no longevity pooling), the median average income falls from 4.1% to 3.2%, with only a 57% chance of outperforming the annuity. This finding shows the beneficial impact of longevity credits and the limitations of drawdown in generating a lifetime income.
We also evaluated the standard DP in terms of sustainability and stability of income; details can be found in our sessional paper, Pension Decumulation Pathways: A proposed approach (details below).
A way forward
There has been limited innovation in the pensions industry to help DC consumers navigate the complex choices and implement robust decumulation strategies. DPs could provide significant assistance by encouraging people to think about their objectives and the relative weight attached to each one, while ensuring that suitable products are provided to achieve those objectives
The IFoA’s Pension Decumulation Pathways Working Party comprises Stephen Hyams (chair), Alec Findlater, Andrew Gilbert, Chris Squirrell, Finbarr Kiely, Huw Davies, Kevin Hollister, Oliver Warren and Tim Jablonski. Its paper was presented at a Sessional Meeting on 17 May 2022 and can be
accessed at bit.ly/PenDecPath
Stephen Hyams is chair of the IFoA's Pension Decumulation Pathways Working Party
Image credit | Getty