There are increasing concerns retirees are not making informed decisions when choosing drawdown funds and could have high exposure to sequence risk, writes Stephanie Baxter.
After almost two and a half years of Freedom and Choice, the retirement income market has changed markedly. The number of retirees choosing drawdown has more than trebled since April 2015 as annuities grow less popular, while providers have responded by introducing new funds tailored to those in decumulation.
However, the Financial Conduct Authority's (FCA) interim findings of its study into the retirement income market have highlighted concerns that a lot of individuals are not making informed decisions.
The proportion of drawdown bought without advice has risen to 30% from just 5% prior to the freedoms, while those who did not take advice purchased drawdown from their current pension provider without shopping around.
With just a week until the FCA's consultation closes to responses, Aegon has now warned some of the investment strategies used in drawdown may expose retirees to unwanted sequence risk - which is the risk of receiving lower or negative returns early in a period when withdrawals are made from an individual's underlying investment.
Risks in drawdown
Research of investment choices made by investors on Aegon's platform found little difference between those in drawdown and those still saving for retirement.
Investors chose funds with long-term investment targets to meet near-term income needs, and tended to stick with familiar strategies and well-known funds, rather than newer, more bespoke solutions.
For those in drawdown, the largest investment flows over the year to Q2 2017 were into multi-asset strategies (45%), followed by equity growth (18%), bonds (15%) and equity income (12%). Aegon says this largely mirrors the strategies used by non-drawdown investors who also favoured multi-asset strategies (46%), followed by equity growth (24%), bonds (12%) and equity income (8%).
The firm's biggest concern is over the high use of multi-asset strategies to manage the balance between risk and return. Although it found most drawdown investors were in funds at lower risk levels than most non-drawdown investors, it argues if drawdown funds are not properly de-risked to meet retirees' short-term income requirements, a big market shock could cut years off retirement income.
Investment director Nick Dixon says while drawdown investors have benefitted from buoyant markets since the freedoms, such strategies "have not been tried and tested in a credit crunch event".
He is "surprised" by the findings as he would expect a different profile for those in drawdown.
"I would expect slightly lower risk investment strategies for people in retirement, which is due to sequencing risk when you're taking income, whereas in accumulation you benefit from market volatility by being able to buy assets more cheaply. It's the opposite in retirement: when you take income, if you're cancelling capital when the price has fallen, you have to cancel more capital to generate the same income. Therefore I would expect to see a capital profile that's less volatile."
The real challenge for those in retirement is that yields on safer asset classes like gilts, are so low.
"One of the reasons discouraging people from taking a lower risk strategy is that the yield on those assets is so low, whereas yields are a bit higher on equities and corporate bonds," says Dixon.
Retirement income funds should include a mechanism to protect retirees against market volatility, but also allow for some growth.
As State Street Global Advisors head of defined contribution (DC) investment strategy Alistair Byrne says: "If you have exposure to equity growth assets in retirement and go through a period of market losses, it can have a very damaging effect on the sustainability of the retirement income. There's a dilemma there - you need a portfolio that generates enough return and growth but you need to protect from downside volatility."
BlackRock head of strategic partnerships and DC investments Claire Finn also defends the role of growth in drawdown: "When you go into drawdown you need to have some risk - around 40% in equity. You can't not take any risk as the pot still needs to grow and ideally provide inflation-adjusted returns so people can maintain their spending power in retirement."
There are investment funds that can help achieve this challenging balance between the two, and manage growth assets in a way that protects from downside risk.
The problem is that drawdown has now become very mass market, whereas before it was typically for high net worth individuals who could afford to pay for advice to create a tailored investment strategy.
Hymans Robertson head of DC Lee Hollingworth says: "Aegon's research shows that although it seems drawdown investors are making informed decisions, it is highly likely they aren't, particularly in light of the FCA's findings on the increase of non-advised drawdown. It's slightly perverse that what was a very heavily-regulated and advised product now seems to be a bit of a free-for-all since Freedom and Choice.
"DC savers get a huge amount of support while in the scheme but when they get to the point where they take benefits, it's left up to the individual. So it's not a surprise people aren't making informed decisions."
There is relatively little appetite among corporate pension schemes to offer drawdown, with most only willing to signpost members to an external provider. There is more scope for master trusts to provide drawdown - where their members can move to drawdown without having to switch to another provider - but it is still early days.
Hollingworth says it is incumbent on the industry to develop better default positions that will suit most members rather than just leaving them to a DIY approach.
Need to innovate
"For some schemes, this isn't a burning platform right now given the number of members coming up to retirement, but it will be as DC matures. We'd like to see within the drawdown process - as we're seeing in the accumulation phase - more of a directive default approach as to what an appropriate strategy looks like in drawdown."
He would also like to see more innovation. "There have been some new fund choices, but the investment community has been a bit slow in adapting to the drawdown market. That may be down to volumes."
BlackRock, for example, looked into launching a specific drawdown product and tested it with advisers, but did not find a great deal of demand, says Finn.
One issue is that most people who have recently retired or are soon to retire will still have some defined benefit (DB) provision and are not relying solely on DC, and will likely have small DC pots. However, that is fast-changing, with the money in DC growing very quickly through auto-enrolment and DB falling away.
The industry must ensure it is prepared for that time. As Dixon says, "There will come a point where the scale is so large that every player will need to have a solution for drawdown that's simple and clear."
The government will set up an infrastructure bank to support investment and to co-invest alongside investors including pension funds.
The Retail Prices Index (RPI) will be reformed and aligned with the housing cost-based version of the Consumer Prices Index, known as CPIH, by 2030, the Treasury has confirmed.
Estatee agent denies a shareholder’s absence from voting is an issue, finds Minerva Analytics.
In this live blog, Professional Pensions' sister title Investment Week collates all the breaking market news, analysis and opinion on equity, bond and currency movements as well as the impact of trade wars, tightening monetary policy and the Brexit negotiations....
Attractive valuations and prospects for economic recovery support small-caps