Best practice de-cumulatisation: a hybrid approach

Given annuitisation of retirement income is no longer compulsory in UK defined contribution funds, NEST has set out to uncover what best practice retirement income distribution looks like. The solution is a hybrid of flexibility and insurance – at low cost. Amanda White spoke to NEST chief investment officer, Mark Fawcett.

One of the newest defined contribution schemes to be set up globally, NEST was faced with a conundrum when the playing field changed dramatically in the UK and it was announced in the UK Budget of 2014 that annuities were no longer compulsory.

The fund reacted as it does with much of the business decisions it is faced with and consulted, with peers, regulators, employers, consumers, academics and its members.

A consultation paper, The future of retirement, aims to uncover best practice for investing for members in the new regulatory environment, stating the opportunity as a once in a lifetime chance to start with a blank piece of paper.

The fund sought to gather evidence to understand the design and retirement solutions that its members wanted and needed. One of the defining characteristics of the consultation and its conclusions is there is no longer a binary debate between annuities and drawdown, rather the solution looks at how both can be combined.

One of the important considerations for NEST is that the way it now manages its members money has been turned on its head.

Under the existing pensions and tax regime it assumed that most members of NEST would use 75 per cent of their retirement pot to buy an annuity and take the remaining 25 per cent as a tax-free cash lump sum.

“We’ve been investing the retirement pots of members approaching retirement in line with this assumption. For members who have recently joined the scheme and are close to their scheme pension age, we’ve assumed that they’ll take their relatively small retirement pots as cash. The changes announced in the 2014 Budget have caused us to reassess whether these assumptions are suitable in a new world of greater freedom and flexibility,” the report says.

Mark Fawcett, chief investment officer of NEST, says for many members flexibility in the early stages of retirement is key, as they will simply not know what their income needs will be.

“Given annuitisation is not compulsory, we asked ‘what’s best practice’?” he says. “In practice, in the early years, people need flexibility. Their needs are different to later in retirement, they might not have stopped work entirely so they might still be contributing, and their income needs differ.”

While in the early stages of retirement flexibility is desirable, as retirees get older they need less flexibility and longevity risk becomes the most important risk.

“In this context then it’s time to get protection,” Fawcett says.

The solution is a hybrid that is a blend of drawdown in the early years and insurance in the later years.

“It doesn’t have to be the same product, but how do you make what’s a complex product understandable and easy to use. The cognitive capacity of retirees diminishes through time, and providers shouldn’t be asking people to make complex annuity decisions at age 85.”

While NEST will publish a full consultation response later this year, Fawcett says it is reasonable that best practice for a defined contribution default would be a combination of existing products.

He believes it needs to be seamless so there are not many tough decisions along the way. A blend of drawdown in the early years and protection, with opt out options, later in life.

From an investment viewpoint Fawcett sees some growth allocation, but not as much as in the accumulation phase of the fund.

“Property is quite attractive for the drawdown phase and some equities. Sequencing risk is greater however, so the allocation would be more like 40 per cent growth,” he says.

“Volatility management is a regulated activity so pension schemes like NEST would have to outsource this.”

Fawcett says in the US some funds are partnering with insurance companies to provide deferred annuities that kick in at age 80 or 85, but in the UK the deferred annuity market is non-existent.

Importantly, whatever the final solution, Fawcett believes it should be good value and costs should be as low as possible.

“One advantage of this solution is the drawdown phase is at a similar cost to accumulation but with some additional risk management techniques.”

One of the challenges Fawcett sees in keeping costs low is to encourage insurance companies to compete on price, and again points to the US where a panel of providers is sometimes used.

“De-cumulation has been somewhat neglected,” Fawcett says, “but we’re looking closer and what can be best practice for our members.”

NEST’s six principles for designing retirement defaults for auto enrolment savers are:
1. Living longer than expected and running out of money is the key risk in retirement and a critical input into retirement income solutions
2. Savers should expect to spend most or all of their pension pots during their retirement
3. Income should be stable and sustainable
4. Managing investment risk is crucial as volatility can be especially harmful in income drawdown-type arrangements
5. Providers should look to offer flexibility and portability wherever possible
6. Inflation risk should be managed but not necessarily hedged