£1.2m or £30k a year for life – which would your clients choose?
That’s the current dilemma facing clients and their families and a place where advisers need to tread carefully, says Mike Morrison, head of Platform Technical, AJ Bell
The UK and the US are different in many ways, not least because we are separated by a rather big ocean, but we do have some similarities, particularly when it comes to behaviour.
Consider the following headlines from March and May of this year:
“Would You Rather Have $1 Million or $5,000 Monthly in Retirement? The answer will tell you whether you suffer an ‘illusion of poverty’ or an ‘illusion of wealth’.”
“Pension dilemma: £659,000 today, or £22,000 a year for life?”
This interested me as in my recent series of pension seminars I have used a very similar observation:
“When you advise a client of their options, let’s say £40,000 per annum for the rest of their life or control of say, £1.4 million in a month or so – what do you think they hear?”
This brings a wry smile from the audience who are all aware that it is usually the big number that sticks out to the clients.
People want and like the idea of immediate wealth – a large sum instantly in their control. They do not think about the relationship between the two and the fact that there will be conditions that need to be met to get from the large sum to the regular lifetime income, as opposed to the ‘guaranteed’ and often (at least partially) inflation-proofed income.
But then the downside – the underestimation of mortality risk (research shows that most people underestimate their life expectancy), the overestimation of investment performance and the lack of knowledge of investment risk and capacity for loss.
In some circumstances, there can be qualitative and lifestyle issues that overrule some of these biases but giving up a guaranteed stream of income from retirement until death is a difficult decision to make.
Occasionally you hear of a case when the two options come into conflict – I remember a story from an adviser (possibly apocryphal but illustrative if it is) of a lady with two sons who were too old to be dependants in accordance with the DB scheme rules.
Their mother was considering a transfer from a DB scheme into a DC plan. For the sake of this article the figures were £30,000 pa or a £1.2 million transfer value – the two sons had visions of at least part of the £1.2 million trickling down to them on their mother’s death. However, the mother realised the value of the guaranteed income and was going to take the £30,000 pa. The result? Family conflict. Extreme, I know.
For me, this is one of the key criteria for individuals considering DB transfers. Cash equivalent transfer values (CETVs) are high, exaggerated by low gilt yields (and other corporate strategies). But even this is not enough – it is not enough for CETVs to be high, people also have to know that they are high and that they might go down.
The result is the wish to transfer – sacrificing a guaranteed income for that illusion of wealth.
In some ways we face a similar question on retirement with the choice between annuity purchase or drawdown. Buying an annuity is a once-and-for-all decision and in some ways a ‘gamble’ (rates, escalation, ancillary benefits), but it does give you a guaranteed income until death, however long you live
Income drawdown is also a gamble depending on investment performance, the perception of investment risk and capacity for loss.
At least the annuity gamble will give you an income as long as you live while, in theory, the drawdown gamble could mean a significant drop in income before death.
This was where I started when I read ‘Why Don’t People Insure Late Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle’, a US academic paper from 2008. This suggested that consumers evaluate annuities in a narrow investment frame that focuses on risk and return rather than a consumption frame that considers the consequences of life-long consumption. The paper considers that, in an investment frame, annuities are quite unattractive, exhibiting high risk without high return but if considered as an insurance against longevity they provide a real solution.
For me, this is why financial planning is so important, as it can add real value, particularly when explaining some of these variables and creating objectivity in the midst of personal behavioural bias.