How to predict member outcomes in the post-Budget world

Needless to say, the flexibility has created additional complication with a member’s need to provide a steady income that can last a lifetime, manage downside risk, protect against the impact of inflation and still be able to meet unexpected needs.

Replacement ratios – income in retirement compared with pre-retirement salary – have traditionally been a measure applied to defined benefit pensions. The aim of achieving two-thirds of final salary provides the classic example.

Recently, defined contribution schemes have attempted to measure success in the same way in order to provide more certainty of outcome for their members. Ever-changing annuity rates complicated this effort since the replacement income depended on what annuities paid.

Even small movements in annuity rates close to retirement could move the replacement ratio completely out of sight. Worse still, changes in annuity rates some distance from retirement age could dramatically increase the required contribution level or reduce the expected retirement income.

Running a risk

Arguably, the greater flexibility introduced by the Budget means members could achieve a given desired income divorced from the influence of volatile annuity prices by drawing down income rather than buying an annuity. But, like all things investment related, it comes with risk.

Glide paths will need to consider protecting a retirement that does not automatically entail annuitisation

In such a scenario, members assume the investment and longevity risk that would normally drive fluctuations in annuity rates. In essence, members will be self-insuring these risks, which could be hazardous.

If members underestimate investment risk or their own longevity, they could run out of money before running out of life. Equally, any investment outperformance could improve the situation, although perhaps overestimating one’s own life expectancy might not be viewed as a positive improvement.

This new view of achieving a replacement ratio obviously complicates things for DC product providers, especially those providing lifestyle or target date funds.

These products have traditionally headed for a 25 per cent cash to 75 per cent fixed interest weighting at a set point in time, usually the selected retirement age, to accommodate the purchase of an annuity.

In future, glide paths will need to consider protecting a retirement that does not automatically entail annuitisation.

DC arrangements will need to consider the position of members that do not crystallise benefits at a set point in time. Likewise, they will need to consider those members who may wish for a seamless transition from pre-retirement to retirement without changing provider or investment strategy.

In reality, this may mean equities exposure will continue past planned retirement, a possibility that radically differs from the current accepted norm.

The industry will also need to understand the spending habits – the drawdown – of non-annuitising members immediately post retirement, alongside the implications for replacement ratios.

For instance, could spending be higher in the first few years after retirement and then settle down to a more consistent pattern?

Should this mean that exposure to equities should also remain higher in the years immediately beyond the retirement date if the rate of spending is higher, in order to provide capital growth to replace the money spent?

It goes without saying that the new flexibility has the potential to completely revolutionise the industry and the retirement patterns of the UK. It is down to schemes and product providers to ensure that such a revolution works in the interests of savers and retirees.

Steven Charlton is defined contribution proposition manager at Vanguard Asset Management