Post-retirement is starting to come into focus for those with defined contributions (DC) pensions. Not only are large institutional DC schemes and master trusts beginning to think seriously about how they provide post-retirement solutions for members, but consensus is also starting to coalesce around what a good post-retirement solution should look like, and general principles are beginning to emerge.
Behaviour since 2015 clearly shows that people value flexibility early in retirement – but, as highlighted in the IFoA’s Great Risk Transfer campaign, we must help individuals to manage their longevity risk, as many are ill equipped to tackle it on their own. There is a role for designed, customisable solutions that help non-advised individuals to draw their benefits while appropriately managing their risks. These solutions must strike a balance between the flexibility of drawdown and the security of annuitisation.
The IFoA Modelling Innovative Pre and Post Retirement Products Working Party has recently published a paper (bit.ly/Ident_innov) that summarises the current state of play and identifies solutions that merit further attention.
One proposal involves combining a drawdown solution with an annuity, either in the form of a baseline annuity to cover non-discretionary spending needs, with drawdown providing flexible income to meet discretionary spending needs, or drawdown in the early years of retirement to suit the needs of an active first phase of retirement, with a later life annuity to provide that longevity protection as well as a lower maintenance approach.
“Do annuities and drawdown solutions provide the tools that are needed, or is there scope for further innovation?”
These approaches are available in today’s marketplace for individuals who take financial advice, but there is a place for designed default options to help pension scheme members navigate these decisions. This is the subject of further research by the IFoA Default Decumulation Working Party. However, do annuities and drawdown solutions provide the tools that are needed, or is there scope for further innovation?
The Modelling Innovative Pre and Post Retirement Products Working Party has been observing with interest the Optimising Future Pension Plans project commissioned by the Actuarial Research Centre – particularly the concept of pooled annuity funds. This is a structure in which longevity risk is pooled but there is no guarantee that members will receive income for life, in contrast to the guarantee provided by an insurance company under a standard annuity product. In a pooled annuity fund’s most basic structure, the funds of members who have died during each period are distributed as a longevity credit to surviving members. Members of such an annuity fund take on both the investment and longevity risks; the key is to ensure that distributions to members are actuarially fair. Pooled annuity funds could provide an efficient way to maximise the value that people receive from their DC savings, but also raise some interesting points:
- To what degree can investment choice be offered to members in such a structure? This can be accommodated in principle, but care is needed to ensure that the size of the individuals’ exposures remains homogenous, for example by paying out investment income rather than reinvesting in the pooled structure.
- For a purely pooled arrangement without insurer involvement, there would be no underwriting on entry to the pool. This could be problematic, as individuals in poor health could join the pool when it is not in their interests to do so, which would work against the objective of helping ordinary individuals to navigate post-retirement risks. Introducing underwriting would mitigate this issue.
- The potential for death benefits to be incorporated into the solution design – whether for funeral costs or for a more substantial bequest – may be beneficial.
- Longevity insurance could protect against systematic changes in longevity risk, over and above the pooling of idiosyncratic risk that the pool provides.
Existing products could also be better used within post-retirement solutions. Variable annuities, which pay a lifetime income that varies with investment returns, are not widely used in the UK; these could provide a good balance between investment freedom and income guarantee, and serve as the backbone of future post-retirement solutions. Equally, deferred annuities would be a welcome addition to the post-retirement arsenal, although the capital requirements for providers currently make them unattractive to offer.
One challenge we see with any kind of annuity is the lack of ability to surrender. People tend to not like tying themselves into a long-term product, without recourse if they change their mind or their circumstances change. The working party believes that this can be alleviated by good design – for example underwriting on surrender, or more widespread use of value protection.
Finally, incorporating equity release products into a retirement solution could provide a valuable additional source of income for individuals.
Finding the best fit
How do you decide which of these solutions – or combination of solutions – is ‘best’? Individuals have diverse needs, and these will change during retirement.
In our report, we also set out our initial thoughts on how we can compare the efficacy of different solutions. We propose to:
- Carry out stochastic modelling to illustrate potential outcomes from different solutions
- Assess each proposed solution by qualitative and quantitative criteria, including the value provided, stability of income, degree of longevity protection and extent of flexibility
- Perform the assessment across different stages of retirement
- Assume that all proposed solutions are wrapped into an overall pension product, so any components that pay out regular income do so back into the pension wrapper and the individual can then take account of their own personal tax circumstances, which will vary between individuals, to manage withdrawals.
This will allow different solutions to be mapped to different preferences; we will be able to identify the best strategy for individuals who value flexibility in the early years but longevity protection in their later years, or the best strategy for individuals who value certainty and security above all else, and so on. We hope to share initial findings from our modelling later this year.
This is an important area for future development, with many unanswered questions. We welcome comments, suggestions and views on the work we are doing, and are particularly interested to hear about any new solutions that are being used in the marketplace. If you would like to share any thoughts,please do get in touch with us at [email protected] or [email protected]
Esther Hawley is a principal and senior investment consultant at Barnett Waddingham, and chair of the Modelling Innovative Pre and Post Retirement Products Working Party
Clarence Er is a director at Leadenhall Capital Partners and deputy chair of the Modelling Innovative Pre and Post Retirement Products Working Party