Adviser > Individual > Drawdown > Managing risk
Managing risk
What is the critical yield?
Critical yield is the rate of investment return required to maintain annuity purchasing power. There are normally two types of critical yield:
- Critical Yield A – used to maintain an income equal to the annuity that could have been purchased at outset, assuming annuity rates are unchanged.
- Critical Yield B – used to maintain a selected level of income.
Factors that affect the critical yield:
| Interest rates | Annuity rates generally vary in line with interest rates. Low interest rates will depress annuity rates. If interest rates in the future are lower than they are now, deferring annuity purchase could lead to the client receiving a lower income when they eventually purchase an annuity. |
| Client's age | Annuity rates are better the older the client and the critical yield is also higher. |
| Increased longevity | A significant improvement in the average life expectancy means that the income from annuities now has to cover a longer period of time, reducing the annual annuity amount. |
| Mortality drag | This is the loss of the cross-subsidy that would have been available had an annuity been purchased. To compensate for this loss the client's plan has to grow faster than it otherwise would. The effect of the loss of cross-subsidy worsens with age, and the impact of this is to increase the critical yield. |
| Spouse's benefits | The initial income payable would be less than for a single life annuity. This means that less investment growth is required to match the income from the joint life annuity than for an equivalent single life annuity and as a result the critical yield is lower. |
| Type of annuity | The type of annuity chosen has an impact on the annuity rates available and the critical yield can change depending on the type of annuity. |
| Charges | The higher the charges applied to a plan the greater the investment performance has to overcome this. The critical yield could increase above the original level. |
| Client's attitude to risk | It's important to consider whether the required rate of return is realistically achievable, particularly in relation to the client's attitude to risk. |
For more information, take a look at our Income Drawdown leaflet on What is the critical yield?.
Is drawdown appropriate if the critical yield is above 6% per annum?
The higher the critical yield, the less likely it is that the fund will be able to purchase the same initial annuity.
The tables in the question above explain how the critical yield is calculated and the factors that may affect it.
For some clients one or more of these factors may outweigh the need for greater investment growth, in particular this could be suitable for those with a higher tolerance to investment risk.
My clients are using a variety of income drawdown services and I review the pension funds on a regular basis. Do you have any suggestions of how to make this process easier?
Drawdown is such a specialist area that requires a lot of work and knowledge. The following are some of the ways you can support your clients:
| Full advice service | For clients that prefer to select their own investments, you will need to have the appropriate skill and commitment to continually monitor your client's attitude to risk, fund performance and to advise them if they need to switch funds to enhance their performance. It is important
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| Automated service | It is possible to set up model portfolios that include regular rebalancing particularly for clients that are not taking any income. This doesn't take into account changes in your individual client's circumstances but it does preserve the risk profile of the portfolio avoiding any drift into higher risk funds. It is therefore possible to offer a service whereby you contact your clients to see if anything has changed in their circumstances and only carry out face-to-face reviews when the answer is positive. |
| Third party help | You could contract this work out to a third party, such as a Discretionary Fund Manager, for your more wealthy clients who can afford the additional charges. These are usually the clients who are looking for more active management. |
The benefits of reviewing regularly:
| Payment | You can be paid for your services which can either be fund based renewal commission (FBRC) or a retainer. |
| Further opportunity | You get regular contact with your top clients, by reviewing their finances and providing ongoing planning, which provides you with further opportunity to earn income. |
With extremes of volatility in investment markets, how frequently should reviews be carried out?
Expectations
The general guidance, as expressed by the FSA and others, is that reviews should be carried out "at least annually" for income drawdown cases. This includes an expectation that more frequent reviews should be carried out when required.
Asset Allocation
Whilst extremely volatile market conditions certainly create a reason for concern for your clients who are taking income from their investments, we would caution against any short term knee-jerk reactions with regard to asset allocation. If the initial risk profiling is correct in light of your client's objectives then the strategic asset allocation should not need to be altered. If your client is unhappy with the levels of volatility then it may be an indication that the risk profile is over-adventurous.
What you could do....
You need to have a system in place that acts to automatically trigger a review. This could be a useful approach however you are then faced with the question of what level to set it. The issue with having a blanket approach to all your clients is there are so many variables such as the amount of income being taken, attitude to risk and term to retirement. A better approach might be to agree an individual trigger point with each of your clients as part of the initial recommendation.
Is income drawdown too risky for my cautious clients?
Income Drawdown and cautious investors
It is thought that income drawdown is a short term contract and should therefore carry less investment risk than a pre-retirement plan.
This is of course true in many cases, as the client requires ongoing access to their benefits, specifically income. However a significant proportion of income drawdown clients are not in fact taking any income after accessing TFC, and may still have a long term savings objective.
Clients who have taken TFC but are not planning to stop work or take retirement income for another 10 years or more do not in fact have a risk profile that is much different than any pre-retirement personal pension plan holder.
So it's all down to the individual's attitude to risk.
For more information on how Scottish Life categorises risk, visit our risk profile web page.
My compliance department won't let me advise income drawdown for funds less than £100,000. Is this right?
How the FSA feels about small funds (fund less than £100,000)
The FSA state that drawdown "may only be suitable" if a client has a large pension fund.
When small funds are acceptable
One circumstance where drawdown could be suitable for a smaller fund is where the client is not actually taking any income as there isn't a need for additional fund growth to replace it. If they are not planning to take any income for another 5-10 years (as is the case with many 55 year olds) then their investment risk profile is unchanged too.
So it is possible that even though the client has withdrawn a lump sum, which will clearly impact on his final pension, the advantages of accessing TFC, for example to pay off debts, could outweigh the disadvantages, especially where the client continues to make contributions into the plan.
Please note that the above is not definitive advice. You should consult your own compliance department to establish their stance on the suitability of small funds. For more information on the advice processes have a look at our leaflet on Income Drawdown And The Advice Process.
Note:
- FSA: Money made clear – products explained/taking an income from your pension.
For professional advisers only
