Exploding the myth

With income drawdown complaints on the rise Fiona Tait takes a look at why this may be and attempts to explode some myths around this product.

Speculation has once again risen that income drawdown could be the latest “pensions transfer scandal”. Like Watergate, it seems that once we’ve had one scandal, everything else must follow the same pattern. But why drawdown? And why now?

It is true that the level of complaints about income drawdown has risen. According to the Financial Ombudsman Service (FOS), the number of new complaints about income drawdown rose from 88 in 2007/8 to 130 in 2008/9,¹ an increase of 48%.

It is however necessary to look at this in context. This is out of a total of 4,825 new complaints about pensions. Payment-protection insurance (PPI) garnered 31,066 new complaints and credit cards 18,590. While many, many more people have been sold these products, the increase in PPI complaints was 192% and 32% for credit cards. Complaints about consumer credit products and services increased by 255%. Even complaints about annuities rose by 60%. So why is this happening?

Falling investment markets

One reason is that clients are much more likely to complain when the value of their investments has gone down than when it has gone up. Walter Merrick, the outgoing chief of FOS, states that “The pages of the financial markets tend to drive complaints against almost anybody. When people’s investments have fallen in value they naturally do turn around and wonder whether they were given the right advice in the first place. If their investments double in value they might have been given totally inappropriate advice, but they do not complain about it. That is just human nature.”²

Unfortunately for those taking income, drawdown plans have actually been hit by a double-whammy. At the same time as markets have fallen, interest rates have also hit an all-time low. As a consequence, GAD rates have worsened and portfolio values have gone down. This is unusual; the expectation is that when equities under-perform, fixed interest investments normally do well.

Complicated product

Another reason is that income drawdown is a complicated product when compared, as it often is, with an annuity. If a client is unable to understand the risks they are taking and, in particular, the potential for loss, then it is difficult to imagine how the product could be suitable for them.

Drawdown is also more expensive than an annuity. This is not a surprise as everyone is doing more work. The provider is administering ongoing contributions and payments, as well as often managing the investments. The adviser is carrying out regular reviews and ensuring the client’s requirements do not change. An annuity on the other hand can be set up and left.

The client

The third reason is that many clients opting for income drawdown are of retirement age, and may not have had much exposure to investment risk in the past. According to the Financial Services Consumer Services panel “there is a question about the capability of older individuals to understand the implications of the decisions that they might/might not take”.³

Of course it is not only possible, but often in the client’s interests, to recommend a more expensive and risky product in the right circumstances. However if you are going to do this you need to have a very robust sales process.

The process must ensure the recommendation is suitable for the individual client under review; it must be capable of delivering that client’s financial objectives; and it must operate within risk parameters which are acceptable to that client.

The FSA has indicated in the past that they consider pensions unlocking “suitable only for a very limited number of people”.⁴ Their ‘moneymadeclear’ website states that “Income withdrawal plans are usually unsuitable if you have a small pension fund, and no other assets or income to fall back on. Even if you have a large pension fund, and other assets or income, income withdrawal may still be unsuitable. It depends on the risks you’re prepared to take”.⁵ It is a good idea to discuss the client’s experience of investments and their attitude to risk before recommending a drawdown arrangement.

The definition of a “small fund” is, in context, less than £100,000, as stated in the FSA’s most recent sanction for mis-selling income drawdown.⁶ The concern is that these small funds will not be capable of providing the same level of annuity income as they could at the point that benefits were taken. It is therefore necessary to measure the sustainability of the plan. What is obvious is that the less income a client takes, the easier it is to maintain the annuity purchasing power.

Financial objectives

Income drawdown is not an annuity replacement though it is sometimes sold as such. It does not suit clients who want to take the maximum possible income with the minimum possible risk. If that is the client’s main goal, and for the majority of people reaching retirement (by which I mean leaving work and requiring a pension income) it still is the main goal, then an annuity is the best option.

But a replacement income is not the primary aim of every client who takes pension benefits, and not all clients who take benefits are retiring from work. Many are younger and have different goals. The need for cash to pay off debts, or to raise business finance, is very often a key driver. Other reasons include wishing to continue to benefit from investment growth, partial retirement and income tax planning.

The key is to identify and prioritise the client’s objectives then make this clear in the suitability letter.

The adviser also needs to ensure they have considered all the options available, in particular whether the client can achieve their goals using their existing plan. Once again the Financial Services Consumer Panel is concerned about the ability of advisers to deal with the growing complexity of products on offer.⁷

The key to getting this right is to concentrate on the client. Basing your recommendations on the client’s agreed financial priorities, it is possible to concentrate on those options which are capable of achieving their goals. Those that don’t may be documented as unsuitable.

Investment objectives

With an income drawdown plan, like any other investment, you need to set an investment goal. To maintain the annuity purchasing power of the fund, it will have to grow sufficiently to offset the inevitable drain on the plan’s assets.

The drain consists of plan charges, the effect of mortality drag and any income withdrawals.

Fortunately the effect of these elements can be measured using the critical yield. Often this is used to determine the investment objective, although the final target may be different after discussion with the client. Once you have a target growth rate you can set up a portfolio that is capable of achieving it, and discuss with the client whether the level of risk that comes with it is acceptable.

Of course this process does not guarantee that the portfolio will achieve the required investment growth; it only targets it. If the client wants a guarantee, there are other products available. Variable annuity plans offer funds with a guaranteed measure of return, although current investment conditions have made this more expensive to achieve and some of these products have been withdrawn altogether.

The investment portfolio must be suitable to the client’s attitude to risk (ATR). A recent FSA sanction cited examples where the clients were assessed as “low-risk”, then recommended to set up a drawdown plan and invest in equities. These two elements do not equate. Low-risk clients may opt for drawdown but his is only likely to be when there is a very strong reason, such as ill health, for them to do so and/or when they have substantial other assets safely invested.

Income requirements

Clearly the higher the amount of income the client takes out of the plan the higher the growth rate required to sustain the annuity purchasing power. Usually it would not be good advice to recommend a client takes maximum income from their plan for a prolonged period of time.

There are exceptions to this of course – the client may have other assets with which to bolster the falling pension income; they may be in ill health and be looking to preserve the pension fund for their dependents; or they may be re-cycling the income back into the pension plan (and yes, it is possible to do this – providing the limits laid out by HMRC are not breached).⁸ If any of these reasons apply, it is important to document this in the suitability letter.

¹    FOS Annual Review 2008/9. Pages 32-33
²    FTAdviser.com – Firing Line: Walter Merricks 6 August 2009
³    Financial Services Consumer Panel Press Release 30 July 2009
⁴    FSA/PN/091/2006
⁵    www.moneymadeclear.fsa.gov.uk/pdfs/income_withdrawal.pdf
www.fsa.gov.uk/pubs/final/cheshire_0729.pdf%20Point%202.2
⁶    www.fsa.gov.uk/pubs/final/cheshire_0729.pdf Point 2.2 (6)
⁷    Financial Services Consumer Panel Press Release 30 July 2009
⁸    www.hmrc.gov.uk/manuals/rpsmmanual/RPSM04104925.htm

Fiona Tait is business development manager at Scottish Life