By Henry Cobbe
The new pension freedoms means that advisers have a key role to play in helping their clients get the retirement they expected. In most cases, that’s unlikely to be a simple choice between cash, drawdown or annuity, but more of a combination of each to match a client’s needs, requirements and aspirations.
When researching the solutions that could help advisers navigate the new retirement freedoms, we looked to the US where annuities have long ceased being the mainstay of retirement income to understand the innovations that can help create more durable retirement portfolios.
From 'to' to 'through'
Lifestyling pensions are managed to a retirement date typically targeting annuity conversion. Target date funds can be managed through retirement targeting sustainable withdrawals from a balance of stability and growth.
The target date is not an end date but a start date for the drawdown phase. It is the turning point where investors move from making regular contributions to making regular withdrawals. The investment objectives gradually pivot from making a pot grow before retirement to making it last in retirement, sustaining a durable income.
Flexible, not fixed
In contrast to old-fashioned lifestyle strategies that follow a fixed investment plan, target date funds enable flexible asset allocation to adjust for the market and economic environment. This is the difference between being asleep or awake at the wheel: the journey looks similar, but it’s who’s driving that counts. This flexibility enables active risk management for a smoother ride for clients.
Partial annuitisation
Annuities’ key feature is to provide guaranteed income in old age until death. That was generous in 1928 when the pension age was 65 and the average age of death was 67; now it’s a stretch as, happily, we are all living longer.
Partial annuitisation may have a role to play to top up other guaranteed incomes, such as DB benefits and the state pension, to help cover a client’s essential spending in retirement. So while most retirees in the UK took 25 per cent cash/75 per cent annuity, about 19 per cent of retirees in the US take some form of annuity with optimal allocation considered to be 25 per cent annuity/75 per cent drawdown on average.
Deferred annuities
Traditional annuities and enhanced annuities would both be termed in the US as 'immediate' annuities as they start paying out at point of purchase. What we don’t have yet in the toolkit are 'deferred' annuities, which start in the future to do what annuities were originally meant to do: to form a perfect hedge to longevity risk.
By combining target date funds with a progressive purchase of deferred annuities, there is scope to get the best of both worlds: a managed portfolio to draw down over time and a longevity hedge for later life, when longevity risk is an insurance worth having. We encourage UK insurers to offer deferred annuities to broaden the retirement toolkit.
A 'bucket' approach
One framework in the US for retirement portfolio construction is the 'bucket approach'. Each bucket includes a cash component for short-term needs, a medium-risk bucket for medium-term needs and a higher-risk bucket for longer-term growth. The allocation to each bucket changes as time goes on, as risk capacity changes with time. With target date funds, allocations to these different 'buckets' is managed within the fund, for convenience, efficiency and value, and enables advisers to focus on more holistic planning decisions.
Bringing it together
Instead of considering a portfolio’s potential for risk and return, advisers are now having to consider retirement outcomes — income replacement and adequacy rates, sustainable withdrawal rates, life expectancy and legacy decisions.
Our accredited CPD series for advisers around retirement investing examines the ‘lifecycle’ framework for combining future income, current portfolio, life insurance and annuity choices to optimise asset allocation over time to consider not only investment risk but mortality risk and longevity risk too.
Old problems, new answers
While none of these considerations are new to advisers, the responsibility for managing them is. The innovation that target date funds provide for a managed drawdown portfolio forms part of the retirement planning toolkit alongside cash, guaranteed income and insurance. It’s for advisers to combine these to create a plan that suits their client’s needs. It’s time to rethink retirement investing and we are here to help.
Henry Cobbe, CFA is Head of Research at BirthStar, the research and advisory firm that worked with AllianceBernstein to create BirthStar target date funds.