At-retirement: Understanding the risks

Vince Smith Hughes talks to Retirement Planner about the challenges facing retirement advisers and how adequate assessment of risk is all important when choosing an at-retirement product.

People moving into retirement today are faced with low gilt yields, rising inflation, decreasing annuity rates and increasing longevity. How much do you think people know about the impact of these factors on their retirement income?

Vince Smith-Hughes: If I'm going from the feedback that I get from advisers then I would say the average person doesn't know very much about these issues. One adviser said to me that many clients are stuck in the past and still think they are getting 5% interest rates on money saved in a bank account and so when you offer them 5% on an annuity, having given up their capital, they think it's poor value. We need to raise people's awareness of the fact that things have changed.

In terms of how we raise this awareness, then there is plenty of information out there for those who wish to seek it out. I think advisers need to use this material to "warm up" their clients in the year running up to retirement by giving them easy to understand information they can digest over a period of time rather than expecting them to take on a lot of information in the final weeks.

For instance, last year Prudential worked with the Retirement Partnership to produce guides advisers can use to help clients understand what they need to focus on when deciding to take a retirement income.

We have seen massive product innovation in the at-retirement market. How much do advisers understand about these different options and how they can apply to their clients?

Vince Smith-Hughes: We as an industry probably don't help ourselves by using terms such as "third way products". There are many different types of products in this space and the differences between some of them are as vast as those between level annuities and conventional income drawdown, so we shouldn't really lump them together in one category.

In terms of levels of understanding, then I think it is growing. The retirement specialist advisers are often a step ahead and are actively using these products but more general advisers aren't at this level yet.

Many advisers still work in terms of either recommending a level conventional annuity or drawdown, with nothing in between. This is like looking at a Ford and deciding that if you don't want that then you'll buy a Rolls Royce instead. There needs to be more consideration of these middle market options.

What are the key issues advisers need to bear in mind when choosing appropriate products and what risks do they need to consider?

Vince Smith-Hughes: Many advisers are cautious about using new products and need to fully understand the different risks involved. For instance if you look at our Income Choice Annuity, then there is an element of investment risk to be borne. If the client wanted to take a high level of income at the beginning of the plan term, then they need to understand that as time goes on their income could fall.

We increasingly need to look at what the worst case scenario is going to be when using various products. For instance, a 65 year old man using an Income Choice Annuity may find they have a guaranteed income of 70-75% of the best conventional annuity rate. As an underpin, that's not bad.

In terms of products, such as fixed term annuities, I can also see how they could be useful. However, advisers and their clients need to understand that this is a drawdown product and they need to think about what annuity rates may look like at the end of the term if they wish to purchase one. You always need to explain the worst that might happen - and its feasible annuity rates could be lower in the future.

What role do you think fixed term annuities will play in the market going forward?

Vince Smith-Hughes: Fixed term annuities can be useful. The only thing I would say is that with bond yields being so low you at present are looking at returns of maybe 2-3%pa. If this is the case then you need to ask whether an income drawdown portfolio could be put together that would offer a better rate of return.

On a wider point it occurs to me some advisers may not be going through the same processes with these products as they would be with income drawdown. If you take maximum income from a fixed term annuity then you need to consider how itthat will affect your annuity income when the times comes to purchase one. This is not a mis- selling issue but advisers need to ensure they can't offer a viable alternative via conventional drawdown which offers more potential upside. It's all about giving the appropriate warnings and exploring new products.

How fit for purpose are middle market products to meet the changing needs of today's retiree? I.e. fluctuating demands for income, mitigating the effect of inflation.

Vince Smith-Hughes: Providers are always coming up with different products and what we currently have on the market is fit for purpose and can be tailored with other products to fit individual clients' needs. Balancing out the different risks is key so, for instance, with a conventional level annuity you have massive inflation risk, whereas if you go for an inflation linked annuity then you have a lower starting income. Clients and their advisers need to understand these different risks and try and balance them out so for instance you may take some investment risk in order to counteract inflation.

There has been a lot of debate about advisers adopting a portfolio approach to retirement with products being mixed and matched at different points in the client's life. Can you give me an example of how this would work? How much of this do you think advisers are doing?

Vince Smith-Hughes: We find the specialist advisers are doing it regularly with many others doing it on an occasional basis but I think it should be more popular than it is. For instance, if you had a cautious client with a £100,000 pension pot and put half into an Income Choice Annuity and half into a conventional level annuity then you've potentially got a high income with a good level of guarantee. You probably end up with a potential downside of 10-15% less than you would get using only a conventional level annuity, but the potential upside is much higher. If you move higher up the risk spectrum and utilise Income Choice Annuity with drawdown then you have all the flexibility that goes with income drawdown alongside the ability to pick funds, and a guarantee via the Income Choice Annuity.

While middle market products such as investment linked annuities can be useful are they only really suitable for those with larger pension pots? How can they be made available to those with smaller pots who may need this flexibility more perhaps in a non-advised capacity?

Vince Smith-Hughes: In short, I think these kinds of products can be offered on a non-advised basis as long as the customer is crystal clear on the pros and cons. Perhaps a process could be put in place whereby the customer can purchase the product on a non-advised basis but receives a series of prompts throughout the process reminding them they can take advice at any point if they need clarification. As long as people understand what they are buying then why not let them buy on a non-advised basis, as long as they understand the advantages and disadvantages?

We currently offer the Income Choice Annuity for pots as low as £10,000 but many of these are AVC funds and the client has a larger pension income elsewhere. We can't assume that just because these products are bought at low values that that is all the client has.

Income drawdown has become increasingly popular. What are the ongoing advice issues advisers need to be aware of as the client goes through retirement?

Vince Smith-Hughes: A few years ago one of the specialist retirement advisers asked why advisers aren't recalculating clients' critical yield regularly in drawdown to see whether remaining in income drawdown works for them. This gives them the opportunity to work out whether annuitisation might be a better option. Ongoing advice is critical for those in drawdown, particularly when there are no guarantees in place. I believe an annual review at the very minimum is required.

However what has also been happeninged in the past is that many income drawdown clients have exited drawdown and moved straight into an annuity - is this the best route for them? Instead they could utilise products such as an investment linked annuity as part of, say, a five year de-risking strategy and move out of drawdown in phases. There's no need to do it all on one day.

The amount of income people can take from capped drawdown has decreased lately due to a reduction in gilt yields and the reduction in max GAD to 100%. Are we seeing shifts in demand as a result say to investment linked annuities?

Vince Smith-Hughes: We are certainly seeing some real demand for this as clients look for ways to de-risk their retirement portfolios. Capped drawdown clients have seen their income reduce massively and investment linked annuities can often offer them more retirement income, and crucially a more sustainable income if that is the key driver..

Vince Smith-Hughes is head of business development at Prudential