By Billy Burrows
MPL Wealth Management.
There is a new way to invest your money when you retire that converts your pension pot into a guaranteed income but which, at the same time, gives you the maximum amount of flexibility.
At retirement, most people use their pension funds to buy annuities.
Although they provide a guaranteed income they are totally inflexible.
The main criticisms are that you lock into current interest rates.
And when you and your partner die, the pension payments stop and there is nothing left for your family.
There is already a more flexible option and that is called pension drawdown but that is quite risky because it involves investing in the stock market and as the recent credit crunch has shown, this is risky.
The new products have been called different names including, variable annuities, third way products and guaranteed drawdown plans.
I prefer the latter because the variable annuities label is misleading and comes from the US.
What is a guaranteed drawdown plan?
It is a form of annuity which originated from the US where mutual funds (similar to unit trusts) offered a range of guarantees in order to attract people to invest at a time when equity prices were volatile.
The particular option that has been exported to the UK is known as a Guaranteed Lifetime Withdrawal Benefit.
This provides a guaranteed lifetime income which is payable regardless of investment returns and there is also an investment lock-in, whereby any gains are secured.
In this way, investors can benefit from a guaranteed income for life without actually buying an annuity.
In addition, if the fund increases in value, the level of income will increase, but if the fund value falls then the income will remain at the level at the last lock in.
On death, the funds can be paid as a lump sum to beneficiaries.
The insurance companies provide the guarantees through a process known as dynamic hedging.
Sophisticated hedging techniques using a wide range of derivatives are used to ensure that the insurance companies can always meet their contractual guarantees.
Investors and their advisers are not expected to understand the rocket science behind dynamic hedging.
But it is important to realise that what is also underpinning the guarantee is the financial strength and solvency of the insurance company.
So investors should ask how strong the guarantees might be if the firm ran into trouble.
There are now several products in the UK that can provide a guaranteed income from a pension drawdown plan and these include:
- Hartford - Guaranteed Retirement Income Plan (GRIP)
- Lincoln - i2Live
- MetLife - Secure Retirement Option
- Aegon - Income for Life
It is important to understand the nature of the guarantee.
It is not a guarantee on a specific fund or index, it is a guarantee that applies to a portfolio of funds.
Typically the investor will pick a pre-selected portfolio arranged by the insurance company and the guarantee will sit on top of that.
The portfolios will be restricted to a certain proportion of equities, though this can be as high as 80%.
The objective for many retirement age investors will be to arrange an income that:
- Keeps its value in real terms
- Lasts for as long as they or their partner are alive
- Doesn't take undue risk
- Has as much flexibility as possible
Until now there has been no single retirement income product that has been able to meet these objectives.
Level annuities fall short because they do not provide a sustainable income and there is no flexibility.
And conventional pension drawdown policies do not meet this requirement because they do not provide an income for life without undue risk.
A guaranteed drawdown meets these objectives because the income for life is guaranteed by the insurance company and the investment lock-in means that investors do not take undue risk.
Flexibility is achieved through the rules for drawdown which allow for income flexibility, control over investments and choice of death benefits.
In short, guaranteed drawdown appears to provide the best of both worlds; a secure income as well as flexibility and investment control.
Have your cake and eat it?
So if guaranteed drawdowns provide annuity style income but with the flexibility of pension drawdown, what is the catch?
There is no catch but there is a cost.
The cost of providing the lifetime income guarantee is taken by increasing the annual fund management charge.
Charges differ from company to company but typically range from 0.75% to 1.5% per annum.
It also important to note that a variable annuity plan can have up to 80% of the funds invested in equities, which is probably a higher equity exposure than for an unprotected drawdown fund.
The new style guaranteed drawdown plans transfer both the investment risk and longevity risk to the insurance company but at a cost.
Is that cost justified? The jury is still out.
The opinions expressed are those of the author and are not held by the BBC unless specifically stated. The material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.