Pension Decumulation Pathways – a proposed approach

Abstract

Decumulation Pathways are proposed to help achieve better retirement outcomes for those with Defined Contribution (DC) pensions. The DC fund is split into two parts, in proportions of the consumer’s choice. Most is allocated to the Pension Fund to provide a lifetime income, while the rest is placed in the Flexible Fund for flexible access and/or to leave as a legacy. The Flexible Fund is invested in flexi-access drawdown. The Pension Fund is invested in a guaranteed annuity, Collective Defined Contribution, or a Pooled Pension Fund which maintains individual DC funds but pools longevity risk between participants. An illustrative standard Decumulation Pathway is intended as a default solution, or can be tailored by the consumer. It uses the Pooled Pension Fund, an automated withdrawal strategy which ensures a lifetime income is provided and one that aims to increase in line with inflation, and a moderate risk investment strategy. The standard approach is evaluated using various metrics, indicating that it has as a strong chance of providing a higher income than could be obtained from an annuity or drawdown, with limited downside risk.

Summary

1. 1. The introduction of Pension Decumulation Pathways can help improve outcomes in retirement for those with Defined Contribution (DC) pensions.

2. 2. Decumulation Pathways is where the consumer determines how their DC fund should be split to cover the main competing objectives in retirement. Firstly, what percentage of the fund should be invested in the ‘Flexible Fund’ (FlexFund) for flexible access and/or legacy provision, and secondly what percentage should be invested in the ‘Pension Fund’ (PenFund), which is used to provide a lifetime income.

3. 3. Suitable high-quality products can then be offered for each of these two Funds, along with associated information and guidance.

Decumulation Pathway product choices

1. 4. Flexi-access drawdown is a suitable product for the FlexFund, but not for the PenFund as it does not adequately manage longevity risk. Decumulation Pathways can help emphasise this point and promote the use and development of alternative products for the PenFund.

2. 5. At present, the guaranteed annuity is the only mainstream product that manages longevity risk, but is unpopular for a variety of reasons.

3. 6. Two potential alternatives to the guaranteed annuity are considered which provide a variable, but potentially higher income:

   • Collective Defined Contribution (CDC) schemes, which are trust-based arrangements where members’ assets are pooled.

   • An arrangement with no universally accepted name but which will be referred to as a ‘Pooled Pension Fund’ (Pooled PenFund), with the following key features:

     • – Maintenance of individual DC funds, with some limited choice in how the arrangement is managed, such as in choosing the investment strategy and the extent to which the income increases each year to reflect the impact of inflation.

     • – Longevity risk is either pooled between the participants or is insured. Pooling is a mutual arrangement, where monies from those who die are transferred to the collective longevity pool, and then reallocated as ‘longevity credits’ to survivors; loss of legacy on death is the price paid for the longevity protection.

Decumulation Pathway design

1. 7. An illustrative ‘standard’ Decumulation Pathway has been designed, which might be suitable for the typical consumer, perhaps employed as a default. The main objective set for this standard is to provide a reasonably stable and sustainable lifetime income, for those consumers who do not wish to purchase an annuity. It provides for:

   • A 10% allocation to the FlexFund, invested in drawdown

   • The remaining 90% is allocated to the PenFund having the following features:

     • – Initially invested in drawdown, followed by a phased transfer to a Pooled PenFund over the age range 75–79 in order to manage longevity risk in the longer term, while maintaining some flexibility and legacy potential in the shorter term

     • – Provision of an income which aims to increase in line with inflation, but is automatically evaluated at the outset and each year thereafter based on what is affordable. This is achieved by reference to the fund value and a single life, inflation-linked annuity rate applicable at each review date, where the annuity is calculated using an interest rate which closely reflects the expected return from the investment strategy adopted

     • – An investment strategy which might be typically described as ‘medium risk’.

2. 8. Modelling suggests that the standard PenFund is likely to substantially outperform the immediate purchase of an index-linked annuity over a 30-year period, underperforming only in the worst economic scenarios. Superior performance is as result of the greater investment freedom, possible in absence of a guarantee on the level of income, but at the expense of a modest degree of income volatility.

3. 9. The standard PenFund also outperforms drawdown, mainly due to the introduction of longevity risk management. This results in a higher initial withdrawal rate being supportable for a given investment strategy; 4% in the example modelled.

4. 10. For DC funds of £150,000 or more, the standard Decumulation Pathway has a good chance of providing an income, along with the State pension, that is sufficient to meet basic needs in retirement, while retaining some flexibility and legacy potential through the 10% FlexFund allocation.

5. 11. A range of alternative Decumulation Pathway designs are modelled for comparison. For the PenFund, this includes variation in the means and timing of longevity risk management, the impact of taking a higher initial income on the sustainability of the income in the longer term, and alternative means of improving income stability. Various FlexFund allocations were also explored across different DC fund sizes.

Product development

1. 12. Market development is needed to enable Decumulation Pathways to be effective. In particular, two alternative products to the guaranteed annuity are considered:

   • CDC schemes require minimal decision making by the consumer. Recently introduced in the UK for single employer purposes, there are ongoing discussions to increase their scope to permit multi-employer arrangements.

   • The Pooled PenFund can offer the consumer more personal choice in how decumulation is managed, with individual DC funds being maintained. A key distinction is that it decouples the management of longevity risk from the ability to set investment strategy. A product operating in this manner is already established in The Netherlands, and there is growing interest elsewhere, for example, Canada. Market research can help evaluate the potential interest in the UK.

2. 13. Products which permit the PenFund and FlexFund to work interactively would be advantageous; for example, to permit the exchange of monies between them or to use the FlexFund to smooth out any volatility in income available from the PenFund. This will be facilitated if both funds reside under the same trust or product and are invested in the same way.

3. 14. Annuity innovations might include purchases under trust, to permit the income to remain within the trust, and to secure lower annuity prices than are available to the individual consumer.

Consumer decision making

1. 15. Quality information and guidance are essential to enable consumers to make informed decisions at retirement. A particular concern is the challenge of explaining the key financial risks of decumulation; longevity, inflation and investment. A focus on average outcomes is deceptive in that it hides the range of uncertainty and so undervalues the benefits of risk mitigation strategies, such as smoothing or insurance. More work on communicating these issues is desirable.

2. 16. It is also important that consumers make decisions about their DC pensions by reference to their wider financial resources, in order to make informed decisions. The Pensions Dashboard will be important in that regard.

3. 17. The standard Decumulation Pathway offers a default approach deemed suitable for the typical consumer, while there could be the option to vary some of the features, such as the choice of investment strategy or FlexFund allocation, and the extent to which the initial income is increased in the future to reflect inflation.

4. 18. Decumulation Pathways can help overcome the challenge of providing ongoing support in retirement, by offering solutions which require minimal consumer decision making once established.

1. Introduction

1. 1.1. This paper has been prepared by the Pension Decumulation Pathways Working Party of the Institute & Faculty of Actuaries (IFoA).

2. 1.2. The Taxation of Pensions Act 2014 introduced so-called ‘Pension Freedoms’ from April 2015, offering flexibility as to how people access their defined contribution (DC) pension funds. This has proved popular, with many people choosing flexi-access drawdown instead of a guaranteed annuity, as discussed further in Appendix A.

3. 1.3. However, there has been limited innovation in the pensions industry to help support DC consumers in this new and more complex environment, especially those with small to medium size DC funds ¹ . The number of people in non-advised drawdown has been a particular cause for concern. Drawdown requires good ongoing decision making to manage the complex risks, which may be undermined by a lack of financial awareness or understanding of pensions, or of cognitive decline with advancing age.

4. 1.4. Pension Wise, a free and impartial government service for people planning their retirement, offers free guidance to those aged 50 years or more on the available choices, but only a small proportion of people currently choose to access that service ² .

5. 1.5. A Decumulation Pathway is a broad concept which aims to help DC consumers meet their financial needs in retirement. An effective Decumulation Pathway would provide suitable high quality, value for money products, along with associated information and guidance. This is the idea behind the Retirement Income Covenant ³ in Australia being introduced in July 2022, while in the UK NEST’s Retirement Income Blueprint ⁴ set out a framework with a similar purpose.

6. 1.6. The introduction of Investment Pathways is a closely related concept, but covering only the management of investment risk.

7. 1.7. Section 2 sets out a proposed framework for a Decumulation Pathway, whereby the bulk of the DC pot is set aside to provide a lifetime income and the rest is retained in a separate fund to provide flexible access and/or legacy.

8. 1.8. In section 3 the risks underlying the achievement of a sustainable lifetime income are explored (longevity, inflation and investment risks), and alternative product types (both existing and potential new ones to the UK) are compared in terms of how they manage these risks.

9. 1.9. Modelling is used in sections 4–6 to design a proposed standard Decumulation Pathway aimed at the typical consumer, which might be used as a default. The performance of this standard is compared with the existing mainstream options of drawdown and an annuity. Alternative design features are also explored for comparison.

10. 1.10. Sections 7 and 8 explore the practical aspects of Decumulation Pathways; product development and how to support good consumer decision making. Finally, conclusions are set out in section 9.

2. Decumulation Pathway Design Principles

Consumer objectives

1. 2.1. The construction of a Decumulation Pathway requires a consideration of the consumer objectives it seeks to satisfy. These objectives can be grouped into three broad categories as shown in Figure 1. To a degree, they are in conflict, as assets used for one purpose are then no longer available for the other purposes.

2. 2.2. A consumer’s DC pension will not usually be their only source of retirement income; there will also be the State pension, and there may also be defined benefit pensions. The Pensions Dashboard will be especially important in helping to collate total pension savings, which may derive from multiple DC funds from different employments. There may also be other forms of savings such as Individual Savings Accounts (ISAs), and potential for equity release from residential homes, as well as support from the wider family. The consumer’s attitude to risk in respect of their DC pensions will therefore be influenced by their significance relative to total available income and realisable assets.

3. 2.3. Flexibility lies at the heart of Pension Freedoms and allows consumers to have some control over how their DC pensions are managed in retirement, both at the outset and on an ongoing basis. For example, the ability to determine investment strategy, or to choose the amount of income drawn each year to meet immediate needs and/or for legacy planning purposes. This flexibility is likely to be a significant reason for the greater popularity of drawdown compared with annuities.

4. 2.4. While an ability to exercise control may seem attractive, it does place a significant burden on the consumer to manage the risks associated with maintaining a lifetime income. Furthermore, flexibility can also be in conflict with the management of longevity risk, as explained in section 3, which is why drawdown is not a suitable product for providing a lifetime income.

Figure 1. Conflicting consumer objectives.

Decumulation Pathways

1. 2.5. Decumulation Pathways would be aimed at the consumer whose main priority is to provide a regular lifetime income, but who wish to put aside some monies for other purposes. When a consumer joins a Decumulation Pathway, the DC fund is split into two components, as illustrated in Figure 2. The majority of the fund is allocated to the Pension Fund (PenFund) to support the lifetime income, with the balance invested in the Flexible Fund (FlexFund) to provide flexible access and/or to be preserved for legacy purposes.

2. 2.6. The transition into a Decumulation Pathway is illustrated in Figure 3. When a DC fund is crystallised, the consumer may withdraw a Pension Commencement Lump Sum (PCLS), and the remainder will be invested in a drawdown product until a lifetime income is required, at which point a Decumulation Pathway should be considered. Ad hoc withdrawals might be made in the meantime.

3. 2.7. Alternatively, after taking the PCLS, if a lifetime income is required the consumer might wish to join a Decumulation Pathway straightaway, missing out the middle step.

4. 2.8. It is envisaged that the FlexFund will be invested in drawdown. The PenFund will start as drawdown until longevity risk management is introduced, at which point one or more suitable products will be used, discussed further in section 3.

5. 2.9. A Decumulation Pathway will not be applicable if the consumer wishes to (a) withdraw the entire DC fund, (b) leave the DC fund untouched, for the time being at least, or (c) have flexible access only.

Figure 2. The purpose of a Decumulation Pathway.

Figure 3. The role of Decumulation Pathways.

Decumulation Pathway design

1. 2.10. Since it is assumed that the consumer will have already taken any tax-free cash required, the extent to which flexibility is needed is expected to be limited, so only a relatively small element would normally be set aside in the FlexFund for this purpose.

2. 2.11. A separate legacy fund has not been included in the design, for simplicity and because legacy can be seen as one aspect of flexibility, in that the consumer can either withdraw monies or leave them as a legacy. The choice of investment strategy in the FlexFund may be different to that in the PenFund, reflecting the consumer’s balance of priorities between the two objectives of flexibility and legacy (with the implied shorter- or longer-term investment horizons).

3. 2.12. While it has been assumed that the PenFund is not required for any legacy purposes once longevity risk sharing has commenced, it would be possible to include options such as a dependant’s pension within the PenFund design.

4. 2.13. It is convenient to divide the drawdown period into phases ^{5 ,4}, to recognise that consumer objectives may change over time. Figure 4 illustrates a Decumulation Pathway with three phases, where longevity risk management is introduced in a phased manner over the age range 75–79 for reasons discussed in section 4. In this example, it has been assumed that the FlexFund is retained for legacy purposes, but in practice some or all of it could be used for ad hoc withdrawals to supplement the income from the PenFund.

5. 2.14. The investment strategy might also vary in each phase, to reflect changing tolerance for taking investment risk.

6. 2.15. The design features of a Decumulation Pathway are shown in Figure 5. The FlexFund is considered further in section 6. For the PenFund, longevity risk management and investment strategy are discussed in section 3, while withdrawal strategy is discussed below.

Figure 4. Illustrative Decumulation Pathway design.

Figure 5. Design features of a Decumulation Pathway.

Withdrawal strategy

1. 2.16. One of the most challenging aspects of decumulation is to decide how much money to withdraw over time. This is taken care of automatically with an annuity and managed collectively under CDC, but with drawdown the consumer must decide.

2. 2.17. An ideal withdrawal strategy should spread the income in an optimal manner, seeking to prevent running out of money before death while avoiding unnecessary frugality by drawing too little. This is a very difficult balance to achieve in drawdown (and is not possible without longevity risk management).

3. 2.18. Generic guidance about the level of income to draw can be helpful, such as the set of rules of thumb ⁶ proposed by the New Zealand Society of Actuaries. These are designed for a set of alternative objectives, and bear similarity to the famous 4% ‘safe withdrawal rate’ devised by Bengen. However, such rules do not take into account changing financial conditions or personal circumstances.

4. 2.19. Various ‘dynamic’ withdrawal strategies have been developed ⁷ whereby the income drawn each year varies in response to investment markets according to a set of rules. Such an approach helps to use the DC fund in a more optimal manner, but introduces some volatility in annual income and is more complex to implement.

5. 2.20. One such dynamic approach will be referred to as ‘notional annuitisation’, where the lifetime income is calculated as the amount having equal actuarial value to the DC fund. This is achieved by applying an annuity rate, but a notional one as an annuity is not actually purchased and the rate used need not be a market one.

6. 2.21. Income in each subsequent period is re-evaluated in the same way, based on the value of the DC fund at the start of the period and reflecting annuity rates at the time. The period between re-evaluations will normally be no less frequent than annual. This approach ensures that the money never runs out, as the remaining fund balance at the end of each year is repeatedly re-spread into the future.

7. 2.22. The notional annuitisation approach has been adopted for the modelling in sections 4 and 5.

3. Pension Fund: Products for Managing the Risks

1. 3.1. Consumer surveys such as one by NEST⁴ unsurprisingly confirm provision of a lifetime income to be their top decumulation priority, and this is the role of the PenFund within a Decumulation Pathway.

2. 3.2. The key financial risks underlying the provision of a lifetime income are as follows:

   • Longevity: the risk of outliving the supply of required income

   • Inflation: the risk that the purchasing power of the available income declines over time

   • Investment: the risk that adverse investment experience results in less income being available than had been expected

3. 3.3. Figure 6 summarises five types of products that can be used for decumulation and how they manage these three risks (highlighted in blue shading).

Figure 6. Types of products available for decumulation.

Longevity risk

1. 3.4. The importance of longevity risk management during decumulation has been highlighted in a recent OECD report ⁸ .

2. 3.5. The only satisfactory solution to managing longevity risk is to share it with others or via insurance, as explained in Appendix B. This is an automatic feature of an annuity, CDC scheme and Pooled Pension Fund (Pooled PenFund), but not with drawdown.

3. 3.6. The guaranteed annuity has not proved to be a popular option, even though it is the only mainstream product able to offer an entirely predictable lifetime income. This has been termed the ‘annuity puzzle’ and is discussed at the end of Appendix A. Variable income annuities used to be popular in the form of with-profits, but the market is now very limited in the UK.

4. 3.7. For drawdown, longevity risk can be managed to some extent through the withdrawal strategy, as discussed in section 2. By reducing the income in response to adverse market movements, the risk of running out of money is reduced, but this may result in the anticipated income proving to be unsustainable in the long term.

5. 3.8. The Pooled PenFund is a type of arrangement which comes under a variety of different names and is discussed further in section 7. It can be regarded as a variant of individual DC (IDC) where longevity risk is shared between the participants or is insured. When the risk is shared, this is achieved by means of periodic reviews (at least annually), when monies from DC funds of those who have died since the last review are gathered into a collective mortality pool, and redistributed as ‘longevity credits’ to the DC funds of surviving members of the arrangement. The loss of the DC fund on death is the price paid for the longevity credits in the event of survival.

6. 3.9. A fair system would imply actuarial neutrality, such that the expected gain on survival (the longevity credit, LC) equals the expected loss in the event of death (forfeiture of the accumulated DC fund, F). For a probability of death of q, this translates into the equation:

   $$\rm (1-q)\ x\ LC = q\ x\ F,\ or\ LC = q\ x\ F/(1-q)$$

7. 3.10. In practice, LC will be dependent on the actual number of deaths in the period and the size of the deceased members’ funds, as well as the method used to allocate the funds of deceased members between the survivors. Administrative practicalities will inevitably mean some departure from pure actuarial ‘fairness’.

8. 3.11. Appendix B provides further commentary on how longevity credits can be calculated, how they support the level of income in later life, and the options for insuring the longevity risk as an alternative to the mutual pooling outlined above. A useful overview is provided by Fullmer ⁹ .

9. 3.12. In a Pooled PenFund, flexibility to manage the arrangement is much reduced, as a consequence of the pooling of longevity risk. This is in order to protect the pool from adverse selection, e.g., if a participant wanted to withdraw monies more quickly on experiencing poor health, in order to avoid losing them to the pool on death.

10. 3.13. The Pooled PenFund discussed in this paper incorporates an automated withdrawal strategy to determine the (variable) income payable each year. This is using the notional annuitisation approach explained in section 2.

Inflation risk

1. 3.14. Full protection against inflation risk is possible only through the purchase of a guaranteed index-linked annuity.

2. 3.15. Where full inflation protection is not required or is considered too expensive, some allowance for expected future inflation can be achieved by purchasing a guaranteed annuity with fixed annual increases, such as 2.5% or an index-linked annuity with capped increases.

3. 3.16. Making provision for expected future inflation means taking a lower initial income than if a level pension is taken. This is because providing an income which increases each year is more expensive than one which doesn’t and so, for a given DC fund, the initial income will have to be lowered to compensate. In practice, the relative value of these alternative income streams will depend on the future rate of inflation and how long the consumer lives.

4. 3.17. The natural desire to maximise income, coupled with the challenge of fully appreciating the potential long-term impact of inflation, partially explains why flat annuities are far more popular than index-linked ones. For example, over the period 2019–21 over 85% of annuities sold in the UK were level ¹⁰ . Consumer choice regarding inflation protection is further discussed in section 8.

5. 3.18. Another consideration is the extent to which people actually need a fully index-linked DC income. This is because there is evidence that suggests consumer expenditure typically falls in real terms in retirement, while the State pension currently increases faster than inflation. These issues are discussed further in Appendix A.

Investment risk

1. 3.19. Assistance in managing investment risk in the run up to decumulation is available in the following ways:

   • Default investment strategies are required during the accumulation phase, designed to provide a suitable investment strategy during the period up to the selected retirement age. Default strategies are very popular among DC participants.

   • Before a DC fund is accessed, FCA-regulated pension providers are required to ensure non-advised customers are offered a suitable ‘Investment Pathway’ for those who, over a 5-year time horizon, wish to (a) leave the money untouched; (b) purchase a guaranteed annuity; (c) withdraw income under flexi-access drawdown; (d) withdraw money over a short period.

2. 3.20. Managing sequence of return risk ¹¹ is a particularly important consideration towards the end of the accumulation phase and during the early years of decumulation. This is where poor investment returns are not fully compensated later because of the money withdrawn in the meantime. One solution is to adopt an investment strategy with a lower sequence of return risk, such as by smoothing returns over time (e.g., see comments on CDC below).

3. 3.21. Limiting withdrawals to the ‘natural yield’ (income generated each year) is another method of managing the risk, but is unlikely to generate adequate income in the long-term. Another approach is to retain a cash balance that can be drawn on when markets fall, for a sufficient period until the markets recover ¹² .

4. 3.22. The use of derivatives and other strategies to provide downside protection to market movements is discussed in Appendix C.

5. 3.23. With collective DC approaches, the consumer is not required to manage investment risk, as it is either transferred to an insurer (where an annuity is purchased) or is managed by trustees (in the case of CDC).

6. 3.24. While CDC pools investments, the way in which it manages investment risk can vary:

   • There is a degree of smoothing of investment experience over the long-term as a result of the way in which changes in income are typically smoothed over time (as discussed in 5.15 and 5.16). This leads to some cross subsidies between generations.

   • Where a financial buffer is used to further smooth investment returns, consumers are no longer directly exposed to market performance and investment outcomes will deviate from the individual approach. This leads to further cross-subsidies between generations, which needs careful management to avoid becoming unfair. CDC as recently introduced in the UK does not allow this.

4. Standard Decumulation Pathway Design

1. 4.1. A standard Decumulation Pathway has been designed, as one which might be suitable for the typical consumer, based on an appropriate and sensible set of objectives for the purpose ¹³ . The main objective assumed for this standard is to provide a reasonably stable and sustainable lifetime income, for those consumers who do not wish to purchase an annuity. The standard might be adopted for default purposes.

2. 4.2. The standard was derived after exploring a range of alternative features which are detailed in sections 5 and 6. It is intended to be illustrative, and in practice would need to be tailored to meet the needs of the consumers to whom it is being offered.

3. 4.3. The standard Decumulation Pathway provides for:

   • A 10% allocation to the FlexFund

   • The remaining 90% invested in a PenFund with the features set out in Figure 7.

Figure 7. Standard PenFund design features.

PenFund design metrics

1. 4.4. In order to evaluate a PenFund design, stochastic modelling has been employed, in conjunction with the metrics described below. A retirement age of 67 was assumed. The methodology and other assumptions adopted are set out in Appendix D, including an explanation of the suitability of the approach adopted.

2. 4.5. A range of metrics has been developed to evaluate the effectiveness of different PenFund designs. Whereas during accumulation the key risk is investment, in decumulation risk needs to be viewed differently ¹⁴ , in terms of the impact on the level and stability of the income.

3. 4.6. Average Income is the average inflation-adjusted DC income in the first 30 years, expressed as a % of the initial PenFund size.

4. 4.7. It is also instructive to compare the PenFund design with a guaranteed index-linked annuity using the same initial fund size. The metric Exceeds Annuity is the percentage by which Average Income (as defined above) from the PenFund exceeds that from the index-linked annuity, along with the probability that the PenFund will provide a higher Average Income than the annuity.

5. 4.8. It is relatively easy to ensure an income lasts a full lifetime, by reducing it, if necessary, in response to adverse investment performance. Where such a dynamic withdrawal strategy is adopted, a more meaningful test is one of Sustainability of the initial income in real terms. This has been defined as the level of income in the 26^th year of retirement divided by the initial income adjusted for inflation over the period. 26 years was chosen as being a sufficiently long period to assess sustainability, while there is a significant chance a consumer will survive to the end of that period (34% for retirement at age 67, based on the mortality assumptions described in Appendix D).

6. 4.9. The extent to which the income varies each year is also a significant factor, in particular when the income falls. The metric Income Stability measures the likelihood that the income over the first 30 years will not fall by more than 5% compared with the prior year’s income. This is shown in nominal terms, as that is what people notice in the short-term, as opposed to the longer-term impact of inflation.

7. 4.10. Finally, Basic Income Buffer is the amount by which the total ‘inflation’ adjusted income (DC plus State pension) over the first 30 years exceeds basic income needs, which are defined as £12,000, ‘inflation’ adjusted. Basic Income Buffer is relevant to a consumer’s individual circumstances and is discussed in section 6.

Standard PenFund design: how it performs

1. 4.11. Figure 8 shows the calculated metrics for the standard PenFund design.

2. 4.12. The initial income is 4.0% of the fund size, but 30-year inflation adjusted Average Income varies considerably according to future investment performance. The results are shown in percentiles; e.g., 4.1% for the 50% (median) Average Income, 5.1% for 75% (upper quartile) and 3.3% for 25% (lower quartile).

3. 4.13. Exceeds Annuity shows how Average Income compares with the immediate purchase of an index-linked annuity. For example, the median Average Income of 4.1% is 37% better than the 3.0% from an annuity. Overall, the standard design has an 82% chance of outperforming the annuity, with a good chance of substantially outperforming. Average Income is only 20% less than the annuity for the worst (5^th percentile) outcome shown.

4. 4.14. Sustainability measures the ratio of actual versus expected income in the 26^th year, where the level of expected income is the initial income of 4.0% increased by inflation. The median outcome shows that the income in that year is 8% higher than expected. The lower quartile income is 26% below expected (74% ratio). The rationale for the choice of approach is discussed in section 5.

5. 4.15. Income Stability shows the proportion of years in the first 30 where the income does not fall by more than 5% compared with the prior year’s income. It should be noted that there are ways of improving income stability in practice, as discussed in section 5.

Figure 8. Standard PenFund performance.

Standard PenFund: comparison with other options

1. 4.16. Figure 9 compares the standard PenFund against three alternatives:

   • Drawdown using the well-known ‘4% rule’, where the income is 4% of the initial fund, subsequently index-linked, with no longevity risk management but the same investment strategy as the standard PenFund.

   • The immediate purchase of an index-linked guaranteed annuity

   • The immediate purchase of a flat (non-increasing) guaranteed annuity

2. 4.17. The metrics for the standard PenFund are highlighted in red and the best results are highlighted in grey text. The same applies to the Figures in section 5.

3. 4.18. The standard PenFund scores highest in terms of Average Income and Exceeds Annuity, except for the worst (5^th percentile) outcomes where the index-linked annuity performs best.

4. 4.19. The drawdown strategy assumes an initial withdrawal rate of 4%, which in current economic conditions is now widely recognised to be too high, although many consumers continue to draw income at that rate, or even higher (see Appendix A). In practice, consumers are likely to adjust the level of income drawn to reflect what they deem to be affordable, but it is hard to optimise the affordable income over the full period of retirement in this way. In contrast, the standard PenFund is better able to support a 4% initial withdrawal rate through the use of longevity risk management and an automated withdrawal strategy.

5. 4.20. An index-linked annuity scores best in terms of Sustainability and Income Stability. Comparison between the flat and index-linked annuities shows the impact of inflation on Average Income and Sustainability; the flat annuity has a much higher initial income and performs better in low inflationary scenarios, while the index-linked annuity is superior when inflation is high.

Figure 9. Standard PenFund versus drawdown and annuity.

5. Alternative Pension Fund Design Features

1. 5.1. The standard PenFund was formulated after exploring the alternative features discussed in this section and summarised in Figure 10. Some of these might be offered to consumers who wish to deviate from the standard approach.

Figure 10. Alternative PenFund design features.

Longevity risk management

1. 5.2. Figure 11 illustrates how pooling longevity risk greatly improves the projected outcomes compared with pure drawdown (having no longevity risk management), as measured across all metrics. A significantly higher, more sustainable and more stable income can be expected; a good illustration of the inadequacies of drawdown to provide a sustainable lifetime income.

2. 5.3. Introducing mortality pooling immediately at age 75 generates slightly better outcomes than when spread over ages 75–79. However, it involves a step change in terms of flexibility and legacy potential.

3. 5.4. It can be seen that introducing mortality pooling at age 80 is less optimal than at age 75, due to the increasing impact of mortality drag with age (see Appendix B). Finally, a phased annuitisation over the age range 75–79 instead of mortality pooling generates inferior outcomes, mainly because of the more adventurous investment strategy retained with mortality pooling, but is still superior to pure drawdown ¹⁵ .

Figure 11. Longevity risk management.

Withdrawal strategy – static versus dynamic

1. 5.5. Figure 12 illustrates the limitations of a static withdrawal strategy, i.e., where the income remains unchanged, irrespective of market movements. While it naturally scores well on Income Stability, it fails to take advantage of favourable investment returns (although it leaves greater residual funds as a legacy) and carries the risk of running out of money. In other words, it is the wrong sort of low volatility; stable until bust. A dynamic withdrawal strategy alleviates these issues.

Figure 12. Withdrawal strategy: static versus dynamic.

Withdrawal strategy – interest rates adjustment to market annuities

1. 5.6. The standard design employs a dynamic withdrawal strategy; the notional annuitisation approach described in section 2, using an interest rate 2.0% p.a. above market rates. This is compared, in Figure 13, with alternative interest rate adjustments.

2. 5.7. Under the standard approach, the median Average Income of 4.1 is similar to the initial income of 4.0, implying it is close to a best estimate based on the investment strategy being assumed. This is further evidenced by a median Sustainability of 108%, implying an income in the 26^th year that is only modestly above the expected level.

3. 5.8. This is analogous to how UK CDC schemes operate, which by law are required to use a ‘central’ (best) estimate discount rate.

4. 5.9. Average Income is fairly similar for all the interest rate adjustments. This is because, in the long term, total available income is largely dependent on investment performance, so that taking more income in early years results in less being available later, although slightly better outcomes arise by taking a lower initial income (as explained in 5.12). Income Stability is also fairly similar in all these examples.

5. 5.10. The key difference lies in the expected shape of income, as indicated by Sustainability. The most cautious approach, using market annuity rates, provides the best downside protection (Sustainability of 76% at the 5^th percentile), but there is a high chance of the income rising substantially in real terms. This is contrary to the evidence that there is a tendency for expenditure to fall in real terms in retirement. Such a tendency also provides some comfort that the worst scenarios under the standard approach are less problematic, as a fall in real income may be tolerable to some extent.

6. 5.11. The difference between the standard approach and using market annuity rates is illustrated in Figure 14, which plots all 1,000 simulations and highlights the same percentiles shown in Figure 13. The standard approach has a much narrower range of outcomes, owing to the initial income being set close to a best estimate. Furthermore, the market rate approach may seem unattractive to consumers in providing an initial income no greater than that available from an annuity, albeit there is a strong chance that the income will increase over time in real terms.

7. 5.12. The standard approach does mean that, should the consumer wish (and be permitted) to purchase an annuity at a later date, there will be some reduction in income when market rates are applied. However, the difference between market and adjusted annuity rates declines with advancing years, and there is also the option of further mitigating the reduction by purchasing a flat annuity rather than index-linked. Furthermore, it might be considered relatively unlikely that a consumer would choose to purchase an annuity after entering into a Decumulation Pathway.

Figure 13. Dynamic withdrawal strategy: notional annuitisation.

Figure 14. Distribution of inflation-adjusted income.

Withdrawal strategy – allowance for inflation

1. 5.13. Figure 15 demonstrates how an index-linked income performs better than a level income, partly due the lower income in early years providing greater protection against sequence of return risk. On the other hand, the initial income is much lower.

Figure 15. Allowance for inflation.

Withdrawal strategy – improving Income Stability

1. 5.14. Figure 15 also illustrates how an index-linked income provides better Income Stability than a level income.

2. 5.15. There are various other ways of improving Income Stability, such as smoothing the changes in income over a period. Care needs to be taken that the smoothing period is not too long though, as that increases the chance of not paying out an appropriate total income in the event the member dies at a point where the smoothing has not fully worked its way through. A smoothing period of up to 3 years say, will reduce such risk. This is less of an issue with IDC, where the balance on death is paid to beneficiaries, but is much more significant in a Pooled PenFund, where the balance on death is redistributed to surviving members.

3. 5.16. An alternative approach to improving Income Stability is one where the level of future indexation expectations, rather than the current level of income, is varied in the first instance. For example, with an index-linked income, if investments perform poorly the current and anticipated future indexation might be reduced to 50% of inflation, say. With further deterioration, future indexation might be removed entirely, before the level of pension is cut. A similar approach would be adopted when investments perform favourably.

4. 5.17. This approach is analogous to how CDC operates in the UK. While Income Stability can be improved, the consumer does not keep their original level of pension increases. For example, a consumer expecting an index-linked pension may end up with a level pension if markets perform poorly and don’t recover; an outcome which might be preferred in the circumstances, but possibly not.

5. 5.18. A further way of achieving a more stable income is to utilise the FlexFund. If the income falls, the FlexFund can be used to make up the shortfall, while if the income is more than required then the balance can be paid into the FlexFund. This is explored further in section 7.

6. 5.19. Finally, income stability can be controlled through the investment strategy.

Investment strategy

1. 5.20. Setting investment strategy is a trade-off between seeking upside potential and managing the downside risk. The strategies mentioned in Figure 16 are described in terms of the extent to which they deviate from the ‘least risk’ approach (whereby investments are fully matched with the cost of providing the pension). Cautious is the closest to the least risk approach (with a 20% equity allocation) and Bold involves the largest departure (having an 80% equity allocation).

2. 5.21. The modelling results present a good case for the Bold strategy, given the extra upside potential and no detriment to the downside risk when compared with Moderate. This demonstrates the potential to take very significant investment risk in the standard PenFund, supported by the allocation of longevity credits (resulting in a longer investment horizon) and the drawing of a reasonably stable income.

3. 5.22. However, the 80% equity allocation for Bold can result in substantial short-term volatility in fund value, which will be of concern to some consumers when individual funds are identified as in the Pooled PenFund (perhaps less of an issue for CDC where the focus is on the level of income). The standard approach has therefore been based on the Moderate investment strategy (with a 50% equity allocation), in an acknowledgement that perhaps the metrics adopted need further refinement to adequately deal with this aspect of design.

4. 5.23. An investment approach which varies over time could be adopted, such as based on the three retirement phases described in section 2. There are various arguments about how this variation might be structured, which are beyond the scope of this paper.

5. 5.24. There is the related consideration of how the FlexFund is invested, noting there may be administrative convenience in adopting the same strategy as for the PenFund. If the FlexFund is intended primarily for flexible access, this would suggest a more cautious approach than if intended for legacy purposes due to the shorter investment horizon.

Figure 16. Investment strategy.

6. Flexible Fund Allocation

1. 6.1. A decision is needed as to how much of the DC fund to allocate to the FlexFund to meet flexibility and legacy requirements within the standard Decumulation Pathway. This is distinct from the PenFund which provides a lifetime income for the consumer only, although it would be possible to also build provision within the PenFund for a dependant’s pension following the death of the consumer.

2. 6.2. A FlexFund allocation of 10% has been chosen for the standard, reflecting the following:

   • It is sufficiently modest such that the bulk of monies are targeted at providing a lifetime income, while offering some flexibility and legacy potential.

   • The consumer may still have access to part of the PCLS (tax-free cash) taken, which may help support a smaller allocation to the FlexFund.

   • For DC funds of £150,000 or more, the remaining 90% allocation to the PenFund has a good chance of providing an income, along with the State pension, that is sufficient to meet basic needs in retirement (assumed to be £12,000 p.a.). This is illustrated in Figure 17 and evaluated more fully below.

3. 6.3. The methodology employed to determine basic income needs and the assumed State pension is explained at the end of Appendix D.

4. 6.4. Basic Income Buffer has been defined as the extent to which the inflation-adjusted 30-year average income (DC plus State) exceeds basic income needs as defined above. Figure 18 shows the results for this metric for various FlexFund (FF) allocations.

5. 6.5. The modelling results support the earlier comment that, for a DC fund size of £150,000 or more, there is good chance of meeting basic income needs, based on a 10% FlexFund allocation. There may also be scope to increase this up to a 20% allocation.

6. 6.6. For fund sizes of £100,000 or less, basic income needs are unlikely to be met even with no FlexFund allocation, based on the assumptions adopted. However, adopting a 10% FlexFund allocation provides some flexibility and legacy potential.

7. 6.7. For fund sizes of £200,000 or more, there is more significant scope to increase the FlexFund allocation from the 10% standard allocation, while retaining a good chance of meeting basic income needs.

8. 6.8. Of course, the extent to which a consumer is concerned about the DC pension being used to meet basic income needs will depend on individual circumstances.

Figure 17. Meeting basic income needs¹.

¹Initial DC fund size £150,000, 10% FlexFund allocation, State pension of £8,400

Figure 18. Flexible Fund and Basic Income Buffer by fund size (in £000’s).

7. Product Development

1. 7.1. A number of product initiatives have been mentioned in this paper that are of potential relevance to the pension decumulation market. These are explored further below.

PenFund & FlexFund in combination

1. 7.2. The PenFund and FlexFund could work together effectively in various ways, such as the following:

   • Money could be moved from one Fund to the other as required (to the extent permitted), either to rebalance them or to reflect revised circumstances or objectives

   • The FlexFund could be used to top up income from the PenFund when it has fallen due to adverse investment performance, or some of the income from the PenFund could be diverted into the FlexFund if not required

   • A very different approach might see all income from the PenFund paid into the FlexFund, leaving the consumer free to draw the amount required

2. 7.3. The ability to operate in any of these ways will depend on how the PenFund and FlexFund are constructed. Where they both reside within the same trust or product, the flows between the two funds would be treated as internal transfers rather than income distributions. Transfers would be easy to manage where the PenFund and FlexFund both retain individual member funds, and especially if they both invest in the same pooled assets.

Annuity innovations

1. 7.4. Similarly, if an annuity is purchased as a trust asset, annuity payments will constitute a source of income rather than a distribution, and so can be kept within the trust. It would also be possible to permit the surrender of the annuity, albeit at a discount. One such product is offered by Just ¹⁶ .

2. 7.5. Trustees of defined benefit schemes can typically obtain better annuity pricing for buy-ins or buy-outs than individuals purchasing annuities themselves, due to their bulk purchasing power. In a similar manner, a Master Trust, say, might be able to enter into an arrangement with a preferred provider to provide cheaper annuity terms than would be available to individuals. Naturally, this would require careful management to ensure good value against the market.

Pooling longevity risk

1. 7.6. Products which provide longevity risk management other than the guaranteed annuity are not currently widely available in the UK. Two potential alternative products have been considered in this paper, the Pooled PenFund and CDC, which are compared in Figure 19. These products offer the potential for significantly higher income than from a guaranteed annuity due to their greater investment freedom, albeit with a variable income.

2. 7.7. CDC offers a straightforward solution for the consumer, especially when also adopted during the accumulation phase. With assets being pooled, and no, or very limited choices to consider, the consumer receives a lifetime income, albeit one that is variable.

3. 7.8. The Pooled PenFund is not a new concept; for example, Blake ¹⁷ referred to it as CIDC (collective individual defined contribution) and it is given various other names in the references mentioned below and in Appendix B. A key distinction is the identification of individual funds, along with the decoupling of the management of longevity risk from the ability to set investment strategy. Furthermore, there is the possibility of offering some choices, which most likely need to be pre-determined, in order to minimise the risk of adverse selection against the pool. Some potential choices are shown in Figure 19.

4. 7.9. Underwriting is mentioned in Figure 19. This is more naturally undertaken where an insurance company is involved and has a cost implication. Impaired lives need particular consideration if they are not to be disadvantaged, in terms of the distribution of longevity credits and calculating the affordable income each year. When making decumulation decisions, consumers need to consider if this aspect is relevant to their circumstances.

5. 7.10. The Pooled PenFund has not yet been adopted widely around the world, although there is growing interest and some innovative products are reaching the market such as offered by Nuovalo and Tontine Trust. In Canada, MacDonald et al ¹⁸ discuss the potential of such products, while Purpose Investments Inc ¹⁹ has recently introduced one. Mercer ²⁰ has operated a similar product in Australia for some time.

6. 7.11. The Dutch variable DC pension ²¹ has been in existence since 2016 and is expected to play a prominent role in the planned new pension arrangements. It has a strong resemblance to the Pooled PenFund modelled in this paper. Market research could help determine the potential demand for the Pooled PenFund in the UK.

7. 7.12. Both the Pooled PenFund and CDC would require legislative change to make them suitable as alternative decumulation options. For the Pooled PenFund this might be based on existing provisions for individual DC, while ensuring that longevity credits do not count towards the Annual Allowance. For CDC, it would build on existing CDC legislation which is for single employer arrangements only, which the Government has expressed a willingness to do in conjunction with the pensions industry.

8. 7.13. Collective products such as the Pooled PenFund and CDC need scale to make them cost effective. The increasing consolidation in the UK DC market is helpful in this regard.

Figure 19. Comparison of the Pooled Pension Fund and CDC for decumulation.

Quality assurance

1. 7.14. Products need to be of high quality and offer value for money. A quality assurance (or safe harbour¹⁷) scheme might be introduced, to certify a product as being Decumulation Pathway approved, and thereby provide comfort and protection to consumers. There would need to be consensus on what the key attributes of such a product should comprise.

8. Consumer Decision Making

1. 8.1. The Working Party’s brief was to consider how consumers can be automatically protected against making bad decisions regarding their pension decumulation.

2. 8.2. Clearly the preferred outcome is that the consumer will make good, well-informed decisions. Decumulation Pathways can help in this regard, with the consumer being encouraged to weigh up the relative importance of competing objectives in order to allocate monies between the PenFund and FlexFund.

3. 8.3. It is also important that suitable products are available to implement the consumer’s preference, which was explored in section 7.

Consumer choice and guidance

1. 8.4. Successfully navigating the available choices requires the provision of high-quality information and guidance. Lindley¹ suggests that, before accessing their DC funds, all consumers should be required to take regulated advice, use the Pension Wise guidance service or go through an opt-out service managed by Money & Pension Service. The new stronger nudge to pensions guidance requirement² will help address this point.

2. 8.5. One possible approach might be an automated decision-making pathway, which could pose a series of questions and offer guidance based on the responses given.

3. 8.6. It is also important that consumers make decisions about their DC pensions by reference to their wider financial resources, in order to make informed decisions, and the Pensions Dashboard will be crucial in this regard. This should reduce the number of cases where the consumer regards the DC fund as being too small to use for a lifetime income. It might also impact people’s decisions about how much tax-free cash to draw, given that it will leave them with less income for the future.

4. 8.7. While guidance and advice at retirement has rightly been given a lot of focus, take up of ongoing support in retirement is less common, and is unlikely to extend beyond investment advice. Decumulation Pathways can help overcome this challenge by offering solutions which require minimal consumer decision making once established.

Understanding risk

1. 8.8. One of the biggest challenges is helping consumers understand the key decumulation financial risks of longevity, inflation and investment. Developing more guidance on these matters would be highly desirable.

2. 8.9. A key concern is the natural tendency for consumers to focus on the expected, median or average outcome; however, it may be termed. Such a simple approach has obvious merit in being engagingly straightforward, but does not reveal the range of uncertainty that exists, and which could impact a consumer’s decision making.

3. 8.10. One important example is life expectancy, which is often underestimated by people. As Appendix B illustrates, people also underestimate the wide distribution of age at death around the average, which highlights why the pooling of longevity risk is so important. By definition, there is a 50% chance of living longer than the median expected lifetime, which makes this a material matter in terms of financial planning. Furthermore, the most likely (modal) date of death is typically a few years later than the median.

4. 8.11. A similar issue arises when considering expected investment returns. For example, while a Pooled PenFund is expected to deliver a higher income than an annuity, there is a range of uncertainty as illustrated in the modelling from sections 4 and 5. Stochastic modelling can be used to explain this uncertainty, but is not straightforward to present.

5. 8.12. A related point is that it is sometimes argued less money is needed in drawdown to provide a specified level of income than if a guaranteed annuity is purchased. Again, this notion ignores the range of uncertainty in outcomes. Such analysis could also adversely impact retirement planning, with lower contributions being deemed necessary if drawdown is anticipated rather than income being provided by an annuity ²² . The current Statutory Money Purchase Illustrations (SMPI) assumptions for DC projections assume the purchase of an annuity, which is therefore prudent in being less likely to underestimate the cost of providing a given level of income.

6. 8.13. In principle of course, in absence of cross-subsidies, the total income achievable over a given period will depend on actual investment performance. Taking a higher initial income will mean less being available at a later date, as discussed in section 5.

7. 8.14. An awareness of inflation risk may also have been undermined by the low inflationary environment experienced for many years, although that has now changed. There is still a danger that the cumulative impact of inflation is underestimated, partially linked to the tendency to underestimate longevity and because it is seen as a more distant problem. This is likely to contribute towards the popularity of level pensions as opposed to index-linked (in addition to the other points made in Appendix A).

Consumer protection

1. 8.15. Ideally people will make well-judged, informed decisions based on quality information and guidance, but it is worth reflecting on how to minimise the risk of poor decision making.

2. 8.16. The standard Decumulation Pathway can provide a degree of protection by offering a default solution deemed suitable for the typical consumer, with a range of options available for those who wish to tailor the product to suit their personal circumstances. Guidance will be important though the help consumers determine if the standard is appropriate for them, or how to modify it if not, within the range of options offered. Providing a standard which varies according to certain criteria, such as fund size, has merit in principle, but introduces additional complexity and could lead to more sub-optimal consumer choices.

3. 8.17. Making the transition from accumulation to decumulation as seamless as possible is convenient for the consumer. This is easily achieved where the consumer is in a CDC scheme and remains so in retirement. A transfer from drawdown to Pooled PenFund can also be relatively straightforward if there is no change in provider, as the individual DC fund is retained. On the other hand, such convenience might not result in the optimal solution for the consumer, who could be better served by re-evaluating objectives and choosing a decumulation approach accordingly.

4. 8.18. Some commentators have suggested making longevity risk management compulsory on reaching a certain age, but this would be very problematic.

5. 8.19. Reintroducing capped drawdown rules and required proof of a secure income before accessing drawdown, would reduce scope for poor consumer choices, but such a reversal seems unlikely and is contrary to the concept of Pension Freedoms.

9. Conclusions

1. 9.1. Many DC consumers currently choose drawdown rather than a guaranteed annuity. While drawdown offers flexibility, it does not provide a reliable lifetime income, mainly due to the absence of longevity risk management. This gives rise to a danger that some consumers will achieve poor outcomes in retirement relative to their expectations.

2. 9.2. Decumulation Pathways can help address this issue by:

   • Providing a framework for consumers to determine the relative weight they attach to competing objectives and apply these weightings to their decumulation strategies

   • Encouraging the development of alternative products for the PenFund, in addition to the guaranteed annuity

   • Providing information and guidance to support consumers in understanding the risks in decumulation.

3. 9.3. A standard Decumulation Pathway suitable for the typical consumer, with some options to tailor it, can help consumer decision making.

4. 9.4. The proposed illustrative standard Decumulation Pathway utilises the Pooled PenFund, a product which is not currently available in the UK but exists elsewhere. It offers the prospect of an income which is variable, but is significantly higher than that available from a guaranteed annuity. Market research can help evaluate consumer appetite for the Pooled PenFund.

5. 9.5. CDC offers an alternative approach to the Pooled PenFund, also with potential to significantly outperform the guaranteed annuity. It generates a lifetime income with minimal decision making required by the consumer, while the Pooled PenFund can offer the consumer more personal choice in how decumulation is managed, with individual DC funds being maintained.