Capital protected structured products can offer a useful means to offset risk when clients start their decumulation journey, says Clive Moore, Managing Director of IDAD.
The crash in value of cautious portfolios in the second half of 2022 was entirely predictable – interest rates were always likely to rise from their historic lows. What was difficult to predict was when the rise would happen, the quantum of the rise and the speed of increases.
Whether it was prudent for ‘low risk’ portfolios to hold high percentages of longer maturity Gilts and bonds is another story, but for investors caught in this crash, it was frustrating to be told they had moved into lower risk portfolios because they needed to preserve capital as they got closer to retirement, only to see their capital massively depleted just when they needed it most!
For those investors using the value built up in their investment portfolios to purchase an annuity, the rise in interest rates was broadly good news, boosting annuity rates. What investors and advisers really want though is to get the best risk adjusted return on their investment, combined with the best level of income when they come to buy an annuity.
Dealing with interest rate risk
Annuity rates are calculated taking into account prevailing interest rates (typically gilt yields to expected maturity) and mortality assumptions (how long the annuitant is expected to survive). For longer term annuities, i.e. those bought when the annuitant is younger, the interest rate element is far more important and so has a far greater effect on the income paid out for the term of the annuity. For annuities bought later in life, this interest rate risk is largely removed as the key determinant becomes life expectancy.
To remove the risk of committing to an income level for the rest of their lives, many ‘decumulation’ clients and their advisers opt to focus on a drawdown policy, or a combination of drawdown and annuity purchase. You’re probably familiar with this ‘two pot’ system. A refinement on this is to hold off buying an annuity until much later in retirement.
Buying an annuity late in retirement has some obvious advantages – more money available for beneficiaries for longer, and an annuity rate that isn’t as heavily dependent upon prevailing interest rates – so less stress about buying at the wrong time.
The challenge though is the risk to capital in a traditional ‘low-risk’ investment strategy – this is where capital protected structured products come in.
A simple solution
Lots of very smart people (and me) have spent years working on post-retirement solutions that deliver a combination of growth, to protect the real value of investments, and income, to fund day-to-day living costs, but there is a simple solution that can make all the difference.
It’s still worth splitting the pot with the ‘no-risk to capital’ part designed to buy an annuity later in life and ensure care costs are covered. This may be at 75-85 for healthier clients or earlier for less healthy clients. The other part can remain invested in a risk appropriate portfolio to generate sufficient returns for day-to-day living and to cover gifts/create an estate.
By the time an annuity is bought, the effect of interest rates on the income it will provide has dwindled significantly (removing a key risk).
Investing the ‘future annuity pot’ in structured deposits delivers ultimate, FSCS-backed capital protection, and peace of mind for investor and adviser alike. As well as the opportunity for returns significantly higher than cash rates at the bank or building society. So a boost to clients’ lifestyles or estate value and the money remains under advice.
And, in case you weren’t aware, structured products (debt issued by global systemically important banks – which will be bailed out by central banks/governments in extremis) are probably the most ‘liquid’ investments your clients will hold – they can typically be sold back to the issuing bank on a daily basis, unlike the Gilt market, where liquidity dried up in 2022 until the Bank of England intervened! So even though the investments may have 3-6 year terms, if investors need to access their cash early, there will always be a sensible price at which the assets can be sold.
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