The freedom and choice reforms have empowered individuals to make decisions based on their unique circumstances. However, this freedom also leads to challenges when making retirement income choices – among them, uncertainty over spending needs and longevity.
At present, many approaching this decision-making process have other sources of income such as a defined benefit pension or income from rental property. For these people, decisions about how they use their defined contribution pot are less critical.
However, active DC membership now makes up more than 70 per cent of all members in a workplace pension. Looking ahead, more and more people will rely on DC savings as their main source of retirement income.
A potential approach is to combine a drawdown product with insurance that pays an income once a certain age is reached
Whether DC-only retirees opt for income via annuity or drawdown depends on their preference for security versus flexibility. Traditional product design does not allow them to have both, but this is ripe for reconsideration.
Annuities provide security without flexibility
Our research into post-retirement member behaviour revealed that many savers experience life-changing events after retirement.
These events changed the original spending needs they had prepared for in the lead up to retirement.
While these events were reported after just one year, over a number of years we might reasonably expect multiple changes in circumstance to impact income requirements.
The uncertainty of spending means members could potentially regret their decision if they are locked into an annuity.
This suggests that, at least in the early stages of retirement, flexible access to savings is crucial. Members need the capacity to allow for change.
Drawdown provides flexibility without security
Drawdown products could therefore be the solution, but this presents another challenge – planning for longevity.
Perhaps one of the biggest unknowns is the length of retirement DC members need to plan for. If people do not know how long they will live, how can they effectively manage their money to make it last?
The degree of flexibility needed may also vary during retirement.
As people approach the later stages of retirement, income requirements typically become more stable – at this point a secure income makes more sense.
It mitigates both the risk of running out of money and the risk of having too much left over.
Defaults must be innovative
If people want and need flexibility in the early stages of their retirement but are looking to reduce the risk of running out of money, can the industry help?
A potential approach is to combine a drawdown product with insurance that pays an income once a certain age is reached.
You could even go one step further by incorporating this solution into the default fund.
Our research has indicated that, presented as longevity insurance, this approach is valued by people and they would be prepared to pay for it.
While this type of insurance is yet to take off in the UK, it is gaining traction in the US.
For example, the US Department of Labor recently provided guidance facilitating the use of deferred income annuities in default target date solutions.
The move resulted in a number of large schemes initiating discussions with asset managers and insurers regarding glide paths that target a combination of drawdown and insurance purchase at retirement.
As this market develops in the US and the DC market matures in the UK, we believe there will be demand for such an innovation on this side of the pond.
Alistair Byrne is head of European DC investment strategy and Emily Barlow is a DC investment strategist, both at State Street Global Advisors
