Analysing Pathway 3 products: Is the solution to decumulation already here?

This is long overdue as the historic focus of defined contribution (DC) has overwhelmingly been on building pots, with the actual retirement part of pensions left almost entirely as an afterthought. Indeed, many authorised master trusts do not offer any kind of decumulation option and there is a perception of a lack of quality options.

How retirees access their savings is incredibly important, and many people will naturally feel unqualified to make such an important decision.

This difficulty has been identified before, and so the Financial Conduct Authority (FCA) pathways were introduced to address the complexities and challenges faced by retirees in managing their pension savings after the introduction of Pension Freedom in 2015. With the removal of mandatory annuitisation, retirees gained unprecedented flexibility in accessing and utilizing their DC pensions. The FCA pathways therefore aim to provide structured and regulated options that are in theory based on sorting pensions savers into four understandable buckets:

• Pathway 1: "I have no plans to touch my money in the next five years" - This pathway is for those who wish to keep their pension savings invested and are not planning to make any withdrawals in the short term.
• Pathway 2: "I plan to use my money to set up a guaranteed income (annuity) within the next five years" - This pathway is suitable for those who intend to purchase an annuity soon and want their money invested in a way that aligns with this goal.
• Pathway 3: "I plan to start taking my money as a long-term income within the next five years" - This pathway is for those planning to draw down their pension savings gradually to provide a regular income over the long term.
• Pathway 4: "I plan to take out all my money within the next five years" - This pathway is aimed at those who intend to withdraw all their pension savings within a short period.

 As the FCA considers rules on guided retirement they will likely use these pathways as a starting point. These pathways are not perfect, there is a big difference between wanting to enter drawdown tomorrow and in five years' time. This difference is becoming more significant as we see the derisking period of DC products reducing, keeping members at a higher risk for longer. In this article we will consider what we believe is the likely focus for long term DC savers as pot sizes gradually increase, long term income in retirement and Pathway 3. While part of the shift away from annuities will have been driven by low interest rates, there is also a desire for flexibility and the ability to leave an inheritance from a pension pot.

Retirement planning is a critical aspect of financial management, and selecting appropriate investment pathways plays a pivotal role in ensuring adequate income post-retirement. Pathway 3 products are designed to facilitate drawdown strategies, allowing retirees to withdraw a specified amount annually while aiming to preserve the capital. While drawdown pathways have been implemented, in many cases it is not possible to actually use these products for drawdown and they are instead intended to be a bridge to some other, perhaps non-existent, drawdown product.

There is concern in the market that more innovation is needed, that appropriate products are not yet available. While DWA welcome innovation, and are aware of some exciting developments happening, we believed it was worth exploring whether the available Pathway 3 strategies were already good enough to be used as drawdown products.

The performance of Pathway 3 products from various providers has been analysed below. We looked at each strategy for a member that is 70 years old today (so 65 five years ago) and tracked the monthly returns of each strategy using the actual experienced returns of the underlying funds (though noting that some of these funds may not have been used as a Pathway 3 product for the full five years). We assumed a starting pot size of £500,000 and assumed a member took an annual salary of £25,000, deducted monthly, with this amount rising by 3% each year. The following chart tracks the residual pot size over the five years.

Changes in Pot Value Over the Last 5 Years

Source: DWA analysis

There is over £150,000 difference in outcome between the strongest performer (LV+) and the lowest performer (Utmost). We can see that LV= has more volatile performance, taking on more risk which over the long term has benefited but has resulted in fairly significant drops in value over the beginning of this year as Trump brought chaos to global markets. It is notable that over half the pots had preserved or increased capital value over the five years despite drawing an income. Despite dips in 2022, which hit fixed income particularly hard, and more recent falls in value this year, overall the five years have seen relatively strong positive returns.

We next project to the future, to examine the longevity of the highest and lowest performers. As before, we assume a pot size of £500,000, and an initial annual payment of £25,000 which rises by 3% each year. At the beginning of the considered period the member is 65 years old. We apply DWA's long term expected returns to the underlying asset classes of the funds. We then use historic volatility to create 10,000 projections of how the two strategies might perform into the future.

• The dotted line shows the median projection outcome at each point
• The dark line shows the path of the last median outcome
• The darkest cone closes to the median contains 50% of all projections
• The next cone contains 80% of all projections
• The lightest outer cone contains 98% of all projections.

An important factor for drawdown is ensuring members do not run out of money. In 2023 the ONS expected a 65 year old male to live for another 18.5 years on average, a 65 year old female to live another 21 years. Factoring in increasing life expectancy over time and the huge downsides of running out of money compared to not drawing enough down we think ideally a "one size fits all" drawdown solution to target maintaining some capital value until at least age 88, or 23 years beyond 65. In practice retirement ages are also likely to get later, particularly as the state pension age moves so shorter time frames will become more viable.

Projections of Remaining Pot Size: Best Historic Performer – LV=

The higher volatility of LV= has led to a very large range in potential outcomes. The median outcome has the pot size running out at around 28 years beyond retirement, well beyond even our longest target of 23 years which more than 75% of outcomes hit. 1 in 10 members projections run out of money by around 19 years with 1 in 100 running out within 15 years, a significantly shorter timeframe which will make a very material difference to members. On the positive side 1 in 10 outcomes see the pot size rising significantly rather than dwindling despite drawdown. In practice we would expect members to adapt their income if their pot size was dwindling too quickly or growing rapidly, but overall this indicates that the strategy has the potential to preserve some capital for many years, though may be at risk of some larger fluctuations.

Projections of Remaining Pot Size: Worst Historic Performer - Utmost

The more conservative Utmost strategy sees a much narrower spread of projected outcomes. The median value is still ahead of our longest target of 23 years. On the lower end numbers are somewhat similar with 1 in 100 projections running out of money by around 15 years and 1 in 10 running out by around 18 years. The difference is more pronounced on the positive end where there is no expectation for significant growth of assets. There is certainly a risk that a too conservative strategy may not generate sufficient returns to sustain the required drawdown rate over the long term.

These projections should be taken with a pinch of salt, while historic risk may have paid off in recent years and be reflected in the volatility, the past is not a guarantee of the future and a riskier strategy at retirement could force members to crystallise steep losses if timing necessitates it.

What should be clear though, is that Pathway 3 products, or at least products looking like Pathway 3 products, should be viable for use as drawdown vehicles. All that remains is for the market to begin offering them more widely, and hopefully at more competitive prices.

Pete Osthwaite is head of DC trustee solutions & ESG research at Dean Wetton Advisory