Tackling the retirement countdown conundrum

I used to watch Channel 4’s Countdown game show with my grandparents – struggling to find four-letter words while they breezed through sevens. Retirement planning today feels a lot like that final conundrum: a jumble of risks, choices, and uncertainties that don’t always spell out a clear answer.

Gone are the days when “save and invest for the long term” was enough. Now retirees face longevity risk, sequencing risk, cognitive decline, and behavioural biases. At the end of March, over £300 billion of defined contribution (DC) assets were already in the phase where savers had started accessing their savings.

That’s why DC providers, advisors, consultants, and regulators are working together to simplify the retirement journey. At L&G, our joined-up approach spans proposition, technology, distribution, and investments. This blog focuses on the investment side, particularly on decumulation options.

Before we begin, here’s a conundrum for you (answer provided at end):

Higher bond yields: A gamechanger

Annuities were understandably out of favour for a long time, with low bond yields feeding through into the rates that providers could offer. For example, financial advisors preferred equities and other assets to target a higher return, as well as the potential to leave an inheritance.

But a lot’s changed since the start of 2022 as shown in the chart below. 

UK government bond yields are around the highest since 2008, while the yield on global equities is around its lowest in 30 years. 

So, the attractiveness of a guaranteed income for life may be more appropriate for some DC savers, compared to remaining invested – particularly given the uncertainty around how long retirees will live. 

Tick, tock, tick, tock

There’s also a second reason why, we believe, interest in annuities will likely rise, which is the gradual shift from defined benefit to defined contribution saving. Over the next decade the proportion of people who can rely on substantial defined benefit pensions will continue to fall, leaving many more retirees with lower levels of guaranteed retirement income. Faced with that more uncertain starting point, the appeal of at least partial annuitisation may grow.

Next, a numbers game

To assess the relative importance of investment and longevity risk we projected thousands of scenarios for both assets returns and how long people live. In each of these, we assessed what withdrawal rate could consistently have been taken until the simulation’s death age, and how much lower that was than if they’d have received on an annuity taken at the outset. We can then work out the average shortfall across all those scenarios. We focus on the downside scenarios only given the very negative impact on people’s happiness in these cases.

At age 67, the average shortfall from investment risk is around 11%, while longevity risk adds another 16%. By age 85, investment risk fades into the background, and longevity risk balloons to a 37% average shortfall. That’s huge.

It might sound counterintuitive, but as we age there’s more uncertainty over how long we’ll each live, relative to the average person of our age. At 65 there’s about a one-in-10 chance of someone living 50% longer than average, while at 85 that’s shot up to almost 100% longer. 

The likelihood of dying rises with age, which means you get a wider and wider distribution between the people living the shortest and those living the longest, relative to the average.

A seven letter word: Annuity

There are two main price drivers for annuities. The first is bond yields, which feed into annuity prices as discussed. The second is the rate of mortality. All else equal, at ages when mortality is higher, for example a 5% rate per year, providers can offer higher annuity rates. This is because some people will have short lifespans and their premiums can be used to help pay those who survive longer. But at 65, the chance of surviving a year is high, leading to little associated benefit in annuity prices. So, the retiree might be better off remaining invested in assets and aiming for significant growth over the year, while also leaving an inheritance should they die during that period.

Or an eight letter word: Drawdown

But for those who choose to remain invested and take drawdown initially, in our view, there are two strong reasons to consider buying an annuity as they age.

Firstly, as we’ve already noted longevity becomes the dominant risk at older ages. And secondly, as mortality rates rise, that feeds through into better annuity rates as explained in the last section.

Our analysis suggests there’s no magic age when the potential switch makes most sense. For any individual, the relative merits of the two solutions will shift gradually and there’ll be a multi-year period where the two are likely similarly attractive, before at older ages buying an annuity becomes increasingly compelling. 

And then of course everybody is different, so for example it can make more sense to buy an annuity earlier for those with somewhat lower than average health even though this probably sounds counterintuitive. After all, why buy an income for life if you’re likely to live less long? The answer is that providers take individuals’ characteristics into account into the rates they offer and so people in poorer health will likely see that reflected.

Dictionary corner

It’s worth mentioning the important role that providers and financial advisors can play in helping people navigate this complex landscape. The initiatives from the government and regulator will help, hopefully providing a solid platform to build on. 

We’re already seeing evidence of that. This includes the rapid progress in guidance journeys, helping those approaching retirement, by simplifying the decision-making process and understanding behavioural biases during this stage. 

Having the expertise on hand to help people who otherwise might miss out on the best opportunities will be a big benefit.

Oh, and the answer to that earlier conundrum? It’s PENSIONERS.