Drawdown has three components – the fund in which the pension pot is invested according to an agreed investment strategy that reflects the member’s preferences and risk attitudes, the arrangement for delivering the pension (for example, a self-invested personal pension scheme), and the withdrawal strategy. But drawdown could not by itself be classified as a safe harbour product, since it does not hedge longevity risk. It can also be expensive if sold in the retail market.
An alternative to drawdown sold in the retail market is scheme drawdown. The scheme itself provides a withdrawal facility together with an institutional asset management solution to meet the decumulation needs of members in early retirement, that is, until longevity insurance kicks in. It is a natural extension of the default fund used by modern multi-trust, multi-employer schemes for the auto-enrolment accumulation stage. Scheme drawdown has the potential to be much cheaper and deliver more consistent results than retail drawdown, due to economies of scale, trustee oversight, and the use of a well-designed institutionally managed fund. Unfortunately, very few companies have so far offered scheme drawdown to their members. This contrasts with Australian superannuation schemes which are beginning to offer group annuities to their members.
A particularly critical issue is the withdrawal strategy. If too much is withdrawn too soon, there is a risk that the scheme member will run out of money while they are still alive. If too little is withdrawn, there is a risk that the scheme member dies with a large chunk of pension pot unspent and could have enjoyed a much higher living standard in retirement.
The US financial planning community developed the concept of a ‘safe withdrawal rate’ (SWR), as exemplified by the ‘4 per cent rule’. The individual withdraws 4 per cent of the fund in the first year and the same amount adjusted for inflation in subsequent years. If the individual is prepared to accept a 10 per cent probability of failure (that is, a 10 per cent chance of running out of money before 30 years), the SWR increases to 4.17 per cent. A 5 per cent withdrawal rate results in a failure probability of 27.5 per cent.
So there is, in fact, no safe withdrawal rate with drawdown. An important reason for this is ‘sequence-of-returns’ risk: if the fund experiences a sequence of poor returns in the early years of retirement – as has happened over the last year − and a fixed amount is withdrawn from the fund, then the fund can become so depleted that no amount of good subsequent performance can compensate and the fund will run out of money very quickly.
