July 16th, 2015
NEST has launched its “blueprint for a retirement income strategy” setting out how it plans to structure the decumulation stage in the world of pensions flexibility. It is an interesting approach which, while not achievable at present, could set the benchmark for how to operate flexi-access drawdown in the longer term.
Last November NEST issued its initial consultation paper examining how it would respond to pensions flexibility. In March an interim response was published, setting out six ‘guiding principles’ for a new retirement income strategy. These were:
- Living longer than expected and running out of money is the key risk in retirement and a critical input into retirement income solutions.
- Savers should expect to spend most or all of their pension pots during their retirement.
- Income should be stable and sustainable.
- Managing investment risk is crucial as volatility can be especially harmful in income drawdown-type arrangements.
- Providers should look to offer flexibility and portability wherever possible.
- Inflation risk should be managed but not necessarily hedged.
There was a touch of motherhood and apple pie about these principles, which certainly looked challenging in terms of drawdown as it currently operates. However, NEST has now brought forward a ‘blueprint for a retirement income strategy’ which makes a serious attempt to meet all its guidelines, even if it does depend on creating a product not yet available in the UK.
The blueprint does not use the term default for what is proposed, arguing that there has to be at least some involvement from the member in triggering the move from accumulation to decumulation. Instead NEST prefers the term “core approach”, which it believes “highlights the need and opportunity for options in addition to the core approach”.
Through its research NEST found that the three top preferences for retirement products are:
- they are guaranteed for life;
- offer inflation-protected incomes; and
- do not carry significant market risk.
As NEST noted with little irony “to a certain extent this is a counterintuitive finding for pension providers as a product fitting this description has been in existence for a long time, in the form of an index linked lifetime annuity”. The trouble is that annuities are not popular and, at current index-linked gilt yields, very expensive.
The NEST alternative starts by dividing retirement into three phases:
- Phase one, typically mid-to-late 60s to mid-70s;
- Phase two, mid-70s to mid-80s; and
- Phase three, mid-80s onwards.
To some extent this echoes the ‘retirement smile’ pattern of expenditure, which starts of high during the early part of retirement, gradually drops as age and inactivity increase and then rises in the final years as care costs mount. However, NEST makes very little comment about long term care costs and stops targeting inflation-proofing at 85.
The trio of retirement phases is matched by a trio of investment “building blocks”:
- An income drawdown fund, representing around 90% of the member’s pot and invested in an income-generating portfolio.
- A cash lump sum fund of the other 10% invested in “cash-like money market instruments”. This is the primary fund that members would use to take out lump sums as the need arises. Over time it could be topped up by any excess investment returns from the drawdown fund.
NEST has not assumed that a 25% PCLS would be taken up front and says “We have been interested to see evidence that the appetite for taking the maximum tax-free cash at retirement appears to be declining, provided the member is confident they will have reasonably flexible access to lump sums as and when they need them”. There is no indication how NEST see the tax structuring of its proposals.
- A later-life protected income fund. This is the key innovation and would provide a fixed, non-escalating income from age 85. The fund would be financed by withdrawals of “around 1.5% to 2% of the pot annually” between age 65 and 75. Up until age 75 this element would remain accessible, but from age 75 onwards it would be locked in as a form of longevity insurance, with no benefit payable on death.
NEST acknowledges that the idea mimics a US product, advanced life deferred annuities (ALDAs), which are single premium products, typically sold when retirement begins. NEST also accepts that the US model is not directly transplantable to the UK because the US lacks the enhanced/impaired annuity market which exists here and that would encourage adverse selection. In other words, only the knowingly healthy would buy and the unhealthy would not provide the implicit subsidy that exists in the absence of underwriting.