The factors that scared off DB pensions and suppressed annuity rates are still around. Will advisers feel the backlash when risks are more apparent?
Recent developments in pensions have accelerated the transfer of risk away from employers and institutions, and on to individuals. But the chances are that advisers will still get some of the blame when things go badly wrong and clients run out of money in their old age.
First, there was the great switch from defined benefit to defined contribution pensions. Economies of scale, intergenerational cross-subsidies and risk-pooling enabled these schemes to keep costs down and smooth out ups and downs.
But in the end, it was the employer that picked up the tab if things went wrong. Ultimately, that risk became too much of a burden.
Changes to accounting standards meant employers were forced to recognise the true liabilities they held on their balance sheets, while their pension liabilities rose as rules for running schemes were tightened. Trustees were no longer allowed to make quite such optimistic assumptions about future investment returns.
Meanwhile, longevity increased inexorably at the rate of about two years every decade. Little wonder the world went largely DC.
The next big development was pension freedoms. While people can now make use of increased flexibility, freedoms have led to the near-death of annuities.
Individuals have the freedom to manage – or mismanage – their own retirement income, instead of insurance companies taking the investment and longevity bet when they retired. Annuities had become very unpopular, with yields more than halving in the wake of declining interest rates and rising longevity.
Unsurprisingly, advisers have embraced pension freedoms and are now closely associated with their promotion and management.
For most clients, who tend to be at the more prosperous end of society, freedoms have a lot going for them: the ability to lock into equity rather than fixed-interest returns, flexibility to draw down when money is needed and leave it invested when it is not, inheritance tax advantages and potential death benefits generally. But we all know DC pension saving followed by income drawdown has its risks.
The two factors that scared off DB pensions and suppressed annuity rates – longevity and interest rates – are still there.
The question is whether advisers will feel the backlash when the risks become that much more apparent.
With some of the risks, the blame falls squarely on the individual investor. Buy a Maserati with your pension pot and do not be surprised when depreciation leaves you with a much-depleted lump sum after very few years.
The real risks to advisers are likely to be more gradual and insidious. Over-optimistic forecasts of returns, pound cost ravaging, sequencing risk, long-term underperformance of equity markets, high charges, inflation, longevity and long-term care needs can all contribute to someone running out of money.
Many clients suffering the fallout will place the blame at advisers’ doors. The fact is some people are almost bound to run out of money before they die. Even if an adviser’s stochastic modelling forecasts 95 per cent success, at least one or two clients will probably outlive their money. And this might happen soon. Fortunately, there are some sensible strategies advisers can employ:
- Managing expectations is crucial, as most advisers are keenly aware. Do not overpromise; make sure clients are aware that stuff happens and the future is a very hard thing to predict;
- Use tools like cashflow modelling to envisage multiple scenarios – not just a single possible outcome that looks like a firm prediction. Help clients monitor their expenditure and keep it in line with their resources;
- Watch out for new products in the pipeline that could help de-risk some portfolios with flexible annuities, long-term care insurance and possibly equity release. De-risking clients’ portfolios also serves to de-risk advisers’ businesses.
Richard Bradley is associate research director at Platforum. Platforum will shortly be running adviser roundtables discussing retirement propositions. Any advisers interested in attending can contact Mariam Pourshoushtari at firstname.lastname@example.org