Issues & Opportunities

De-risking your drawdown book

1. Background

2. A Positive Review!

3. The Outcomes

4. What are the Risks of Drawdown?

5. What are the Issues?

6. Your Process and Plan

7. The file review process

RU 55 is ten years old in 2008. This wonderful piece of highly prescriptive regulation was introduced by the PIA in August 1998 and is still in force today. The rules are quite clear and with hind sight we can now say what a good piece of regulation this was.

The update clearly states that advisers should keep up to date with market developments, in product and regulation, should understand mortality drag, and mortality gain, and should most certainly be doing an annual review.

Strangely for our industry little has changed for the drawdown client from a regulatory point of view. “A day” simplification brought in a 5 year review of maximum income levels and the reduction to zero for minimum income requirements. However the wonders of market innovation have now started to take effect and we see new products on the market offering guaranteed returns, fixed incomes and maturities, as well as a plethora of new annuity options and shapes.

The issues of mortality drag have been well documented and hopefully need little explanation to the adviser, although the same may not be the case for the client. However the concept of mortality gain may only be known in the sense that this is somehow built into conventional annuity pricing. It may not be known that mortality gain can now be seen as an explicit feature of new annuity style products in the market. The impact of mortality drag must be fully understood and explained.

The requirement upon the adviser is to keep up to date, and to review the exiting drawdown every year.

All too often we have seen the adviser being hammered in the press for the bad work they have done. This activity is not negative. It is not driven by a review of past mistakes.It is a positive review of existing client situations, in the light of new developments in the market. We need to face facts; the market has changed and we need to recognise this.

I believe that this is an area where the adviser can be positive and pro-active. “We agreed on income drawdown as the best course of action for you, however the market has now changed so much that wee of should review this once again and make sure that you are still in the right place.

In addition for those clients nearing the end of their time in drawdown, i.e. they are over the age of 72, the adviser should be opening up the discussions to see agree the best future course for the client and the exit strategy they will adopt, to move the client on from drawdown.Just because the regulation says you have to move out at 75 does not mean it has to wait until then.

It is important to think about what you want to achieve from this work. This will be something you have to decide for yourself, however for me these may be:

• We have reviewed all our drawdown clients
• The client situation has been confirmed and "next steps" agreed.
• Clients understand and are content with the level of risk they are carrying
• The advice practice knows exactly what work will need to be done and when

RU55 clearly states the risks that should be identified to the client: 

• High income levels may not be sustainable
• Taking withdrawals may erode the capital value of the plan, which could result in a lower income when an annuity is eventually purchased.
• Investment returns may be less than shown in the illustration
• Annuity rates may be at worse level when annuity purchase eventually takes place.

I would re-phrase and add to these as follows:

• Stripping the fund out will mean you will not get as big an annuity on exit as you would have done on entry
• If you want to preserve annuity purchasing power be very careful about the level of withdrawals you take from the fund.
• Investment returns could be positive or negative – so agree the investment strategy and goals.
• Annuity rates do fall and have fallen.  They may continue to do so.  Likewise new annuity options are available and may be developed giving enhanced rates for say smokers.
• If you are looking to preserve annuity purchasing power then Mortality Drag is a real drain.  For clients in their 70’s this is likely to be over 1% per annum, and increasing year on year.  Watch it!
• Drawdown is a fixed term investment – not a long term investment.  Therefore targeting annuity purchase at 75 may need a specific investment strategy, unless the exit strategy has been agreed and annuity is not to be purchased. So know the exit strategy! 
• Know the purpose to the plan – it will dictate everything.  Are you there for death benefits – Asset stripping – flexible income – or a combination?
• If using drawdown for income then recognise that “withdrawal risk and investment risk” are key to success.
• Know how the plan fits into the client’s retirement asset pool.  Is this all the client has, or do they have other assets as well? This will help decide upon the level of risk they can carry.

Firstly view this as a positive exercise rather than a negative review.  When we talk about issues we are talking about the issues you should be raising with your client in the next 12 months.  This is not an “adviser bashing” exercise.

Firstly all advisers should be aware of Regulatory update 55.  It is 10 years old this year, and stands the test of time.  It is still in force and its content is largely spot on    - although as above should be developed.

RU55 states certain activity requirements and knowledge requirements, most importantly, it states that the adviser must conduct an annual review, and the adviser should be aware of mortality drag; mortality gain; critical yields; and new developments in the market.

I read into this therefore that an annual review may need to take into consideration the issues noted.

The current issues for a drawdown review are:

(1) Mortality drag for the over 70’s.  This is well documented, although we will be looking at new data on this soon.  Mortality drag for those at 70 is over 1% per annum.  This means that for those over 70, who are looking to preserve annuity purchasing power, you need to generate an addition 1% per annum in investment performance to match the annuity level you could have bought at the start!  And as you get older it gets worse!

Did you know that there are products out there that offer the reverse – It is generally called mortality gain – or mortality credit.  Look at RU55 there is nothing new here with issue – although there is with the products.

This means that you could have the same investment environment as drawdown; with a 10 year guarantee period for death benefits; with flexible income levels allowing up to 120% of the best annuity rate; and mortality gain benefit, awarded through the allocation of bonus units every year. 

See the difference?

This product development is through product innovation and regulation change combined!  It is new and should therefore be considered as part of the annual drawdown review.

Just think if at 70 mortality drag is 1% - then mortality gain could be the opposite – this creates a simple sum – minus 1% plus 1% equals a 2% performance differential! 

(2) Exit Strategy:  It is important for those in drawdown to know why they are in there, and how they are getting out.  Otherwise it could go all very wrong.

The options will depend on the age of the client.  This is NOT an activity that should be left until age 75 or 74 ½

• ASP: A less attractive option now.  Income limited to ******. Death benefits just get hammered with tax unless the client wants to give to charity.
• Lifetime Annuity: possibly with guarantee for 10 years, is attractive particularly for the high longevity client.
• Impaired life annuity:  Attractive for those in poor health, or detrimental lifestyle – alcohol and nicotine.
• Flexible annuity, including asset backed:  continuing the investment advantages and therefore the hedge against inflation, with added mortality credit and flexible and enhanced income levels will be attractive to those that just detest annuity, and have a mixed retirement asset pool.
• The cocktail – and the stagger!  Would it be good to combine the options and stagger the transfer from drawdown into options?  Often the most appropriate solution will be a mix of the above.

(3) Review of advice given:  The market has developed.  Fact.    It just may be that the client who went into drawdown a few years ago would actually now prefer to have an element in a flexible annuity, or a drawdown with guarantees.  New products are now on the market – there is an option to move now.

The client circumstances may have changed.  An illness may have occurred.  Attitudes may have changed.  They may have got divorced! 

Plus the normal issues that should be raised at the drawdown review.
The annual review offers the adviser an excellent opportunity to at least start the process of deciding what the client will do post drawdown.  A number of issues will come into play with clients in drawdown in their 70s.

• Attitude to risk may change, or harden. It is well documented that individuals have the tendency to get more cautious as they get older
• Awareness of health and longevity is much greater.  Serious illness may have developed or occurred – or the individual may be in their second youth
• The need for death benefit will be clearer – with spouse and dependent health known.
• The flexible annuity alternative with mortality credit may become more attractive.
• The future income and capital needs in retirement are probably better known, with awareness of inflation risk high, and the need for  long term care a real concern.
• The retirement asset pool can be re-defined i.e. is the property in or out?

Where to start and how to ensure that the job gets done is critical to success.
The following is just a starter for ten, and I suggest that a more detailed approach is adopted.  However this will depend upon your style and the level of resources available to you.

The key areas you may like to consider are:

(1)The Outcomes: Note the outcomes that you want to achieve from this project.  We have suggested:

• We have reviewed all our drawdown clients
• The client situation has been confirmed and “next steps” agreed.
• Clients understand and are content with the level of risk they are carrying
• The advice practice knows exactly what work will need to be done and when

(2) Establish a data file: If you have a back office system this is simple.  Extract the data into an excel sheet or other format.  Keep it simple! What we are looking for are clients in drawdown, and some additional useful information.
e.g. name; contact details; age; marital status; fund size; product provider.

There will be things that it is great to know, that you will probably have to find out in the process, such as the aim of the product, i.e. is it a max GAD case, Nil income; or an income generator? This information will assist in categorising – or segmenting the client data, and prioritising the work.

(3) Establish a project team – People engagement is a key to success, so who is on the team?

Identify the key personnel who will be involved in the project.  In a larger firm it may be advisable to have a larger team with representatives from each section of the business, such as compliance, adviser, marketing etc,
For a small firm – just do it! – but also set up your process.

Make someone responsible for the project. It is always good to know that just one person in the business sees the project as their baby – and their responsibility to deliver a completed project.

Create a virtual team where possible. This is particularly useful for the smaller firm, and also useful to bring in missing skill sets. An obvious resource which is often under used is the product provider business development team. Ensure non disclosure, and confidentiality agreements are signed.

So, you now have someone who sees the project as their own baby and also a team in place.

(4) Design the process: The way you complete this project will need to suit your own business model, however here are two basic methods:

• All at once - set a timescales for the review, say three months and go about reviewing the cases within this timescale. For the average firm this may be too big an event, and commitment.
• Within the annual reviews, over the coming twelve months. The annual review has to take place regardless, so why not categories cases in the approach to the review period and simply conduct a more in depth review in the coming year.

My choice is actually a combination of these.  So, identify the higher priority cases you need to discuss sooner, and schedule the rest within the annual review programme.

Note:is there anything else in this project that you need to be recognising, discussing with your client?

The basic process can then be set up for cases:

• Initial case data review - identify the priority cases and schedule remaining
• Priority cases identified with D.O.B. before 1.1.1936  - i.e. identifies those in the final stages of drawdown.
• Letter issued to client informing them a review is taking place and why.  Establishes that contact will be made in x number of weeks.
• Priority cases categorised.  See below
• File reviews begin with options established
• Client meeting takes place to discuss options, and possible activities.
• Any changes are implemented
• Non priority cases review begins
  • Pre event letter issued to client
  • File review with options established
  • Client meeting takes place.

As a  result of these activities the adviser firm should know for each drawdown case:  the category of drawdown, and the expected exit strategy.

The outcomes as noted, should therefore be fulfilled.

(1) Categorise the case

• Zero income drawdown
• Max Gad Merchant
• Flexible Income generator
• Other

Each of these categories will have a different set of requirements, and will have had a different experience of drawdown.  Each will look towards a different future.

(2) Desk based fact find

Is there enough in formation on file to complete a supplementary fact find, based on The 12 Critical Factors©

Most importantly:

• Have circumstances changed?
• What death benefits are required?
• What does the retirement asset pool look like?

(3) Examination of exit strategies

• Life time annuity
• Impaired life annuity
• Flexible unit linked annuity
• With profit annuity
• Alternatively secured pension

(4) Client communication issued, with educational material and case based data.

(5) Client meeting to discuss.

(6) Mapping future activity

Once the client meeting has taken place and decisions made the case can be scheduled for future activity. 

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