People approaching retirement are being urged not to jump into income drawdown schemes following cases of individuals taking on too much risk with their savings because of poor financial advice.
The warning comes as the Financial Ombudsman Service, which resolves disputes between firms and their customers, has highlighted a number of cases where individuals have taken unnecessary risk with their pension pots after being wrongly advised to go into drawdown instead of buying an annuity.
Income drawdown schemes have risen in popularity partly because of growing discontent with annuities. Annuity rates have fallen sharply over the past decade on the back of declining interest rates and rising life expectancy. In addition, while buyers of annuities receive an income for the rest of their lives, they must kiss goodbye to receiving their pension fund as a lump sum. By contrast, with income drawdown schemes, or unsecured pensions as they are now known, individuals can draw an income from their pension fund while it is still invested and defer or avoid buying an annuity.
The option has become popular with wealthier individuals who see annuities as inflexible and poor value. Many are also turned off by the fact that annuities restrict ways to pass on wealth to heirs. Over the past year, sales of income drawdown schemes doubled to 25,000 new contracts . However, this rising interest has coincided with a crop of complaints to the ombudsman, largely about advisers not spelling out the risks .
In one case cited by the ombudsman, a man in his 60s was advised to shift a £600,000 pension into drawdown to fund the purchase of a property and meet mortgage repayments. The investment performed worse than expected, leaving him in shortfall and forced to remortgage. “We did not think Mr J should have been advised to enter into an arrangement that put his income at risk,” says the ombudsman newsletter. “We established that he could, instead, have bought an annuity that would have ensured the mortgage payments were covered.”
In another case, a financial adviser told a customer that a pension fund withdrawal arrangement would not “erode” his capital. The adviser defended his advice on the grounds that the customer was “annuity-averse”, because he wanted to pass funds to his children. “In view of the rosy picture the IFA had painted of the pension fund withdrawal arrangement, it would not be surprising if Mr B had appeared to be ‘averse’ to an annuity,” says the ombudsman. “That did not mean he would not have bought an annuity, if the risks of the alternative arrangement had been explained to him.”
However, Fay Goddard, deputy directory-general of Aifa, says some IFAs with basic qualifications may be giving advice in a specialist area. “I would suggest that people looking for advice on drawdown speak to an adviser with an advanced qualification in retirement planning options,” she says.
“Drawdown is a technical area which is very complex. It is also very much based on an individual’s circumstances and their long-term objectives whether or not drawdown is suitable.”
“We would also strongly recommend that our members are appropriately qualified to give advice in this area.”
Others who deal with pension complaints believe that many people are wrongly turned off annuities because the benefits of “mortality cross-subsidy”, an uplift to income provided by those in an annuity pool who die early, are not properly explained to them.
“The mortality subsidy means that people who die younger subsidise the funds of those who live longer than expected,” says Des Hamilton, technical advisor with the Pension Advisory Service. “This is the benefit of an annuity as there is no risk you will outlive your assets, as is the case with drawdown. Sadly this is probably not very well understood by many selling drawdown.”
If you go into drawdown you need to be aware of costs – which can run to 1 to 2 per cent of your funds under management annually – as well as the cost of losing the mortality subsidy.
For younger retirees, aged around 60, this amounts to an additional annual performance drag of around 1 per cent a year. As a general rule, if your benchmark is to beat the income you would have received had you bought an annuity, for a 60-year- old your annual return should be around 8.5 per cent a year (assuming a long-dated gilt yield of 4.5 per cent, mortality cross-subsidy loss of 1 per cent a year and annual charges of 2 per cent). For a 75-year-old, this annual hurdle will be more than 9 per cent.
“If you have only got £40,000-£50,000 of pension assets, and no other source of income, then it is highly unlikely that income drawdown would be suitable as the costs are relatively high in relation to the fund and investment risk,” says Hamilton.
The ombudsman, which receives 10-15 complaints a month about drawdown sales, says it is not enough for advisers to say they put their clients’ money into higher risk arrangements because that was the only way to meet retirement income objectives. “We would expect the adviser to have clearly explained the position to the client and if both the client and adviser decided that the higher risk investment was the correct one to proceed with, to have the reasons carefully documented,” says the ombudsman’s office.
If you want advice on drawdown, look for an adviser with the G60, K20 or AF3 advanced qualification. Chartered financial planners and certified financial planners are also qualified to give drawdown advice.
