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Shining a light on drawdown suitability

Author Image Les Cameron Head of Technical
17 minutes read
Last updated on 5th May 2020

Background

We are on the cusp of an investigation into the suitability of drawdown and wider retirement income advice. To consider what the results might be, we need to look back in time.

Five years from freedoms

Back in March 2014 George Osborne wrapped up his spring budget with a bang – no one ever had to buy an annuity again.  Pension freedoms had arrived, with a series of interim measures opening up access before the big day, 6th April 2015.

He’d totally changed retirement income advice.  But had he? 

Total access to their pension funds was available to everyone, where before it was effectively only available to the high net worth.  But the fundamentals of retirement income advice were surely the same.  And are they the same today?

Everyone has an amount of income they require to meet their retirement objectives, and those of their dependants in the case  of untimely death.  This will be partly what they “need” i.e. money to keep a roof over their head and feed themselves, and what they “want” – the extras which some might see as “nice to have” but others “need to have”.  If you really want to be able to afford your football season ticket or three or four opera outings a year then it’s a need I guess, or a “discretionary” need.

In principle, needs should be met with a secure income, unless the retiree is willing to accept the risk of providing it from their assets.  Crucially, should those risks manifest themselves, the retiree must have the capacity for loss such that there is no material long term detriment to their standard of living.

Since April 2015 there has been an explosion in the amount of people choosing to forego secure incomes.  Scheme pensions have been given up, with high volumes of defined benefit transfers to defined contribution schemes.  Drawdown has become the default retirement option instead of the security of a lifetime annuity.

What were two niche, high risk advice areas, have established themselves into mainstream planning.

Concerns arose about the suitability of DB transfer advice and have resulted in several consultation papers and policy statements.   The first of these “Advising on Pension Transfers CP17/16” was in June 2017 with the resulting PS18/6 the following March. Alongside PS18/6 we had “Improving the quality of pension transfer advice CP18/7” with the resulting PS18/20 that October.   We still await the outcome of “Pension transfer advice: contingent charging and other proposed changes  CP19/25” with the policy statement now delayed to later in the year.

The FCA expressed their high level concerns on DB suitability in October 2017 and followed up with more granular key findings in December 2018.

At a high level failures were driven by firms

  • failing to obtain enough information about clients’ needs and personal circumstances
  • failing to consider the needs of the client alongside the client’s objectives when making a recommendation
  • not making an adequate assessment of the risk a client is willing and able to take in relation to their pension benefits

If we are shining a light on drawdown suitability then why the focus on the suitability of defined benefit transfer advice?

Suitability is about assessing the client’s circumstances, attitude to risk and capacity for loss.  You then identify needs and objectives resulting in recommending something suitable to meet them in a way that the client understands. Isn’t it?

Retirement Income suitability hinges on finding the correct balance of secure and unsecured income to meet the client’s needs and objectives. 

It stands to reason that, defined benefit transfers and drawdown are route to achieve the same client outcome.   So, by looking at those areas of defined benefit transfer advice requiring improvement and the FCA’s expectations of advisers, it should show us, or give us an idea,  where shortcomings in drawdown advice might be found.

When covering appropriate pension transfer analysis (APTA) the FCA said:

“Advice on giving up safeguarded benefits should be based on the individual client’s circumstances and backed up by robust financial analysis which looks at the differences between the benefits offered by the ceding scheme and the benefits being considered as an alternative to that scheme, irrespective of how those benefits are taken. As each client’s needs and objectives are different, we consider that advisers are best placed to consider the detailed approach which is appropriate for each client.”

Might a future paragraph read:

“Advice on accessing drawdown pension for retirement income should be based on the individual client’s circumstances and backed up by robust financial analysis which looks at the differences between the benefits offered by the purchase of a guaranteed income stream and the benefits being considered from using flexible pensions, irrespective of how those benefits are taken. As each client’s needs and objectives are different, we consider that advisers are best placed to consider the detailed approach which is appropriate for each client.”

Spot the difference?

So let’s take a look at what came out of the DB investigations. Will that shine a light on drawdown suitability.

Personal Recommendations too general

Some objectives were just too general.  Client’s wanted a flexible income, a higher income or better death benefits.  As if they had been lifted and dropped from the pros and cons section of a textbook.

It’s a personal recommendation that is made, so granularity into the circumstances that are driving those objectives should be sought and written down.  Where there are several objectives understanding the basis for the relevant importance of each objective should also be covered, especially if they are competing objectives.

Wanting to take control of their pension was seen as a transfer driver which needed robust justification.  Will we see not wanting to pass control to an annuity provider as a client objective? And will that need robust justification too?

Clients objectives should have a richness of personal detail to make them “real” and a reality of circumstances that make them valid.

It’s inconceivable that the same sort of things will not be found in a drawdown file. 

Objectives need to be fully explored.  We clearly need to understand a client’s priorities but crucially an adviser has to be able to adequately assess whether the client is able and willing to take the risk of the approach recommended to achieve their objectives.

Attitude to risk

The FCA found firms failing to assess, or using flawed methods to assess, the risk the client was willing to take in relation to their benefits.

Traditionally risk analysis (and many of the tools that support this) focus purely on the investment risk.  There’s no doubt that’s a key consideration, but it does not cater to the specific risks associated with foregoing a secure income.

When risk was assessed more widely than just investment risk, it was found to be of insufficient detail. More worryingly, the language used was biased towards, or worded in such a way, that a client would respond in a certain way i.e. favour a transfer.  Benefits overplayed, disadvantages downplayed.

This led to the emergence of “attitude to transfer risk” in PS18/20 where the FCA “expect advisers to focus on the client’s attitude to the features of both a safeguarded benefits scheme and of a flexible benefit scheme”.

Is it fair to assume the FCA will expect advisers to have focused on the client’s attitude to the features of a secure lifetime income against an unsecure income? 

Will we see robust assessments of the client’s attitude to not having a secure income for life, using impartial language, in the assessment of drawdown suitability? It must surely be an essential part of the drawdown advice process.

Capacity for loss

Has not always been adequately handled and many advisers reportedly struggle dealing with capacity for loss adequately.  I have seen a file where a client’s attitude to risk was deemed to be medium and the client felt that they had the necessary capacity for loss.  I read on expecting the adviser to have done some analysis to demonstrate that the customer did actually have capacity for loss, but it was absent. There was a mention of “belt-tightening”. The key to CFL is analysis.  Attitude to risk is what clients think.  You do not need to ask a client what they think their capacity for loss is, you should be able to determine it from the information gathered. 

If CFL was an issue in defined benefit advice it must certainly appear in drawdown advice as it’s not a transfer specific problem.

Managing risks

Linked to attitude to risk is the strategy for managing those risks.  This is retirement income so the key risks are inflation, capital erosion and longevity. 

Has a strategy been agreed and implemented? That might be leaving enough cash to fund a few years income, the regular creaming of funds in profit to provide the income, the use of smoothed funds, or separate investments targeting growth and income delivery. Clearly, this would be linked to a review schedule that meets the customer needs.

It doesn’t really matter what it is, it just needs to be clear, suit the client and be done.

Needs versus objectives

In the contingent charging consultation paper some advisers were said to be “little more than order takers” related to an unwillingness or otherwise for advisers to challenge a client’s objectives.

Intuitively, we know that when someone seeks out advice they will usually have objectives in mind, probably not buying a Lamborghini!    But client objectives are of secondary importance. The most important thing is what the client needs and that should be the foundation of the advice process. You should meet the needs of the client and then and only then consider the objectives should they differ A client pushing objectives over needs must by definition be insistent.

Competing objectives, for example the desire to provide death benefits at the expense of income, need challenged. Likewise unrealistic objectives.

Will drawdown suitability uncover inadequate challenge of a client’s objectives.   I have seen cases where one of the objectives of a DB transfer was to provide death benefits for the family, when they were adult,  all grown up, and with no whiff of dependency.  Mum’s essential spend was just being met until average life expectancy assuming the modelling assumptions were met.

Objectives were met but needs may not.

The problem was no death benefits if they stayed put. It’s reasonable to foresee the same thing only with “poor” death benefits after annuity purchase being the “issue”. 

The client’s objectives for their DB transfer are likely to be similar to their objectives from drawdown. All being equal will we see “order taking”?

Which leads to…

Alternative means of meeting objectives

We have seen failings due to the prioritisation of ‘death benefits’ for spouses and dependants in the event of the client’s untimely death without exploring alternative options. In the context of transfers this was potentially the use of life insurance paid for from the scheme pension payments.   With drawdown advice I expect the same to apply, although those payments would be coming from the annuity income.

There was also the consideration of partial transfers, allowing  some secure income to meet core needs with the balance to take advantage of the benefits of flexibility.

There should be no excuse for this not being considered in drawdown advice as, unlike partial transfers from DB Scheme, partial annuitisation of DC pension pots will almost certainly be available.

Where annuity is discounted to provide better death benefits, has annuity protection been explored, giving the balance of secured income with the availability of a lump sum on death?  This means  your capital is not “lost” to the annuity provider on early death, undoubtedly at the “cost” of a lower secured income.    

Likewise is the risk of the actual funds driving the death benefits being depleted adequately explained and understood?  Having a legacy to pass on is wonderful but if the fund is depleted, or exhausts, was the risk to your income worth it?

A key driver of transfers was the perceived lack of value of death benefits where the member was to die early in retirement or did not have any qualifying dependants.  Annuitisation, albeit slightly nuanced as dependants or nominees could be selected, carries the same “problem”.

So, in theory the same shortcomings should appear.

Modelling

Cashflow modelling is, to all intents and purpose, compulsory as a way of demonstrating to clients and helping them understand the longevity risk and sustainability of income from their pension pots.

The understanding of the limitations of modelling tools was covered in the DB work.  Likewise, the use of stochastic modelling and whether it is actually understood and meaningful to clients is debatable.

Where deterministic modelling is used it is important that enough stress testing is done to create a fuller picture and understanding of the risk being taken.  “If you’re fund grows at 4% after charges everything will be OK” does not cut the mustard. 

One of the key call outs from the DB work was advisers failing to take into account longevity prospects beyond average life expectancy when assessing the suitability of income.  By definition very few people are average and half of all people are above average.  So it’s clearly necessary to model sustainability scenarios to a reasonable period beyond average life expectancy.

Modelling demonstrates the sustainability of DC pension funds, it’s not transfer specific, so the same issues must surely show up again in the drawdown space.

Consideration of relevant information

The quality of fact finding came in for some criticism in the DB findings.  I’ve no doubt advisers know their clients and have detailed discussions with them about their finances. The fact find is a critical  document and should actually show that they do. Good fact finding is crucial as good information is required to make good decisions.

Some firms failed to consider relevant information about their client’s needs and circumstances when making a recommendation.  An example was failing to consider the client’s other assets or pension schemes and how these could be used to meet the client’s objectives.  Another was failing to consider the client’s actual health, as opposed to the client’s perception of their risk of early death, which may often solely be based on the early death of family members.

One example given of this failure to obtain the necessary information was recommending that clients use their tax free cash to repay debt or buy a property without obtaining details about the amount needed or exploring alternative finance options.  Another was assuming that the client wants or needs a similar income to what they are currently earning, instead of obtaining details on what retirement plans the client actually has or what their income needs are likely to be.

What I consider the most serious failing around information was the failure to gather adequate information about what the client’s actual expenditure needs in retirement were going to be.  This is fundamental. The primary objective for almost all retirement income has got to be ensuring the bills are paid until you and your dependents die. 

Unless adequate information can be gathered on income and expenditure retirement income advice cannot be given.

One of the key inadequacies of this lack of income and expenditure information was it led then to an inability to adequately explain how the DB scheme and proposed alternate scheme could be used to fulfil the client’s income needs and other objectives

This lack of consideration of expenditure needs in the drawdown world will lead to the same inadequacies.  However, it will be the inability to adequately explain how secure income options and unsecured income options could be used to meet those needs and objectives.

Analysis

It was noted that there was sometimes an overreliance on meeting a critical yield, produced by a TVAS, in DB advice and that it did not necessarily lead to good outcomes.

TVAS ignores client needs and objectives, attitudes to risk and capacity for loss.  It also relies on each assumption being met to be accurate which is unrealistic.  

The exact same problems exist with drawdown yields, so anyone placing an overreliance on the meeting of them are not necessarily going to be delivering good outcomes either.

Contingent charging

I guess it would be remiss not to consider the “hot” issue of contingent charging.  Many see it as a conflict of interest for some advisers leading to advice to transfer, to generate the fee income from the transferred pot, and unsuitable outcomes.

This same issue should not be present in the drawdown suitability findings as that initial charge can be received form either the drawdown pot or annuity purchase price.

The FCA have said they are keeping an eye on ongoing advice charges, which can be just as valuable as initial charges. It will be interesting if they find drawdown recommendations have been on the back of the contingency of ongoing charges. Time will tell.

Conclusion

It’s probably worth saying the above has focused on the “at retirement” decision point but in reality this decision, considering all the relevant issues, should be made at least annually. Circumstances, needs and objectives change over time, so, a drawdown review is a new retirement income decision isn’t it?

The DB work was mostly against a backdrop of reasonable investment performance so not many clients will have felt the pain of investment downside.  Conversely, the drawdown work will be against a backdrop of many people having felt the investment pain.  More complaints?

There are clearly different considerations and drivers in DB transfer advice and drawdown advice.  Much  higher values are involved with transfers. There’s no going back into your scheme once you have left. Many do it well before retirement age. Life changing amounts of money.  It well life changing, but will it last for life is the key issue.

With drawdown advice you are actually at the point of accessing funds so no issues with “why now?”. With drawdown “why now” should be “because there is no suitable alternative”.  But a lot of pension funds are small to average and might be seen to provide a secure income that’s “immaterial”. The secure income, which might well be required in financial planning theory, does not match the perceived value  of accessing all your fund.  Is an extra £100 a month really better than renewing your car, paying off the mortgage and taking what may well be the only opportunity you’ll ever have of visiting your grandchildren living at the other side of the world? I guess that’s an insistent client story.

There are specific considerations on DB transfers that require the trained eye of the pension transfer specialist that don’t apply in drawdown.

But if we focus on suitable personal recommendations, I’d suggest the differences can be considered nuanced. The fundamental, big ticket issue is the same - getting the correct balance of secured and unsecured pension that delivers a suitable outcome for the client.  With a file that demonstrates that is so.

The end of the investigations into the suitability of defined benefit transfer advice has seen the necessity for an APTA.  This appropriate pension transfer analysis helps document clearly why the client outcome is suitable.

If we accept the suitability considerations are fundamentally the same, then it will presumably follow that similar suitability issues may well emerge from investigations into drawdown suitability. 

To address any issues might that follow through to what might be called Appropriate Retirement Income Analysis?

Might retirement income advice, whether DB to DC or drawdown versus annuity, just need an ARIA?

Then everyone is singing from the same songsheet on documenting suitable retirement income outcomes. 

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