Analysing Pathway 3 products: Is the solution to decumulation already here?

How retirees access their savings is incredibly important, and many people will naturally feel unqualified to make such an important decision.

This difficulty has been identified before, and so the Financial Conduct Authority (FCA) pathways were introduced to address the complexities and challenges faced by retirees in managing their pension savings after the introduction of Pension Freedom in 2015. With the removal of mandatory annuitisation, retirees gained unprecedented flexibility in accessing and utilizing their DC pensions. The FCA pathways therefore aim to provide structured and regulated options that are in theory based on sorting pensions savers into four understandable buckets:

• Pathway 1: “I have no plans to touch my money in the next five years” – This pathway is for those who wish to keep their pension savings invested and are not planning to make any withdrawals in the short term.
• Pathway 2: “I plan to use my money to set up a guaranteed income (annuity) within the next five years” – This pathway is suitable for those who intend to purchase an annuity soon and want their money invested in a way that aligns with this goal.
• Pathway 3: “I plan to start taking my money as a long-term income within the next five years” – This pathway is for those planning to draw down their pension savings gradually to provide a regular income over the long term.
• Pathway 4: “I plan to take out all my money within the next five years” – This pathway is aimed at those who intend to withdraw all their pension savings within a short period.

As the FCA considers rules on guided retirement they will likely use these pathways as a starting point. These pathways are not perfect, there is a big difference between wanting to enter drawdown tomorrow and in five years’ time. This difference is becoming more significant as we see the derisking period of DC products reducing, keeping members at a higher risk for longer. In this article we will consider what we believe is the likely focus for long term DC savers as pot sizes gradually increase, long term income in retirement and Pathway 3. While part of the shift away from annuities will have been driven by low interest rates, there is also a desire for flexibility and the ability to leave an inheritance from a pension pot.

Here I think Peter is getting himself into trouble. If we offer people everything from one fund it ends up being a mess. You cannot please people planning to mitigate IHT with a fund designed to pay income, you cannot have the drawdown to meet your whims and expect the fund to protect you for the rest of your life.

Retirement planning is a critical aspect of financial management, and selecting appropriate investment pathways plays a pivotal role in ensuring adequate income post-retirement. Pathway 3 products are designed to facilitate drawdown strategies, allowing retirees to withdraw a specified amount annually while aiming to preserve the capital. While drawdown pathways have been implemented, in many cases it is not possible to actually use these products for drawdown and they are instead intended to be a bridge to some other, perhaps non-existent, drawdown product.

Non existent at present because we do not have a market for or a product called “deferred annuity”.

There is concern in the market that more innovation is needed, that appropriate products are not yet available. While DWA welcome innovation, and are aware of some exciting developments happening, we believed it was worth exploring whether the available Pathway 3 strategies were already good enough to be used as drawdown products.

Yup, if drawdown is good enough and we guess right how much can be taken and how much held back then we have of course solved the nastiest hardest problem in finance!

The performance of Pathway 3 products from various providers has been analysed below. We looked at each strategy for a member that is 70 years old today (so 65 five years ago) and tracked the monthly returns of each strategy using the actual experienced returns of the underlying funds (though noting that some of these funds may not have been used as a Pathway 3 product for the full five years). We assumed a starting pot size of £500,000 and assumed a member took an annual salary of £25,000, deducted monthly, with this amount rising by 3% each year. The following chart tracks the residual pot size over the five years.

Changes in Pot Value Over the Last 5 Years

Source: DWA analysis

We note the providers who work with the FCA on pathways, they are an interesting group and do not include three out of the four DC plans that have exceeded “scale” of £25bn (Lifestyle, Nest and People’s Pension), Drawdown is a retail game, it is not yet a default for small pot providers which of course include NOW, Cushion, Smart and Lewis.

There is over £150,000 difference in outcome between the strongest performer (LV+) and the lowest performer (Utmost). We can see that LV= has more volatile performance, taking on more risk which over the long term has benefited but has resulted in fairly significant drops in value over the beginning of this year as Trump brought chaos to global markets. It is notable that over half the pots had preserved or increased capital value over the five years despite drawing an income. Despite dips in 2022, which hit fixed income particularly hard, and more recent falls in value this year, overall the five years have seen relatively strong positive returns.

This is great, Pete and team are looking at historical returns and providing what is effectively a league table. Corporate Adviser’s new service will no doubt be providing an insight into VFM in retirement – as well as when “building up the pot”/

We next project to the future, to examine the longevity of the highest and lowest performers. As before, we assume a pot size of £500,000, and an initial annual payment of £25,000 which rises by 3% each year. At the beginning of the considered period the member is 65 years old. We apply DWA’s long term expected returns to the underlying asset classes of the funds. We then use historic volatility to create 10,000 projections of how the two strategies might perform into the future.

• The dotted line shows the median projection outcome at each point
• The dark line shows the path of the last median outcome
• The darkest cone closes to the median contains 50% of all projections
• The next cone contains 80% of all projections
• The lightest outer cone contains 98% of all projections.

An important factor for drawdown is ensuring members do not run out of money. In 2023 the ONS expected a 65 year old male to live for another 18.5 years on average, a 65 year old female to live another 21 years. Factoring in increasing life expectancy over time and the huge downsides of running out of money compared to not drawing enough down we think ideally a “one size fits all” drawdown solution to target maintaining some capital value until at least age 88, or 23 years beyond 65. In practice retirement ages are also likely to get later, particularly as the state pension age moves so shorter time frames will become more viable.

Projections of Remaining Pot Size: Best Historic Performer – LV=

The higher volatility of LV= has led to a very large range in potential outcomes. The median outcome has the pot size running out at around 28 years beyond retirement, well beyond even our longest target of 23 years which more than 75% of outcomes hit. 1 in 10 members projections run out of money by around 19 years with 1 in 100 running out within 15 years, a significantly shorter timeframe which will make a very material difference to members. On the positive side 1 in 10 outcomes see the pot size rising significantly rather than dwindling despite drawdown.

Now this is real stuff, this is a view of what the future might be and while “mindfulness” tells us to live in the now and not speculate about the future, actuaries really have to think about probabilities in the future. What actuaries are not very good at, and IFAs probably better at, is working out how good people are at getting the adjustments to their drawdown right, IFAs will say that you need to give them pretty well power of attorney (fiduciary management) over the drawdown – if the capacity of those in later lives makes people incapable of taking rational decisions.

In practice we would expect members to adapt their income if their pot size was dwindling too quickly or growing rapidly, but overall this indicates that the strategy has the potential to preserve some capital for many years, though may be at risk of some larger fluctuations.

Projections of Remaining Pot Size: Worst Historic Performer – Utmost

The more conservative Utmost strategy sees a much narrower spread of projected outcomes. The median value is still ahead of our longest target of 23 years. On the lower end numbers are somewhat similar with 1 in 100 projections running out of money by around 15 years and 1 in 10 running out by around 18 years. The difference is more pronounced on the positive end where there is no expectation for significant growth of assets. There is certainly a risk that a too conservative strategy may not generate sufficient returns to sustain the required drawdown rate over the long term.

These projections should be taken with a pinch of salt, while historic risk may have paid off in recent years and be reflected in the volatility, the past is not a guarantee of the future and a riskier strategy at retirement could force members to crystallise steep losses if timing necessitates it.

Here I think Pete gets a little lost again. If we can’t take the past as a guide for the future, what can we take? I thought that’s why we did history classes at school.

What should be clear though, is that Pathway 3 products, or at least products looking like Pathway 3 products, should be viable for use as drawdown vehicles. All that remains is for the market to begin offering them more widely, and hopefully at more competitive prices.

What is brilliant about Pete’s work is that it helps us with a way to work out VFM for “pensions”- as non-experts call retirement income. The article shows how hopeless pure drawdown is if people live too long or the fund does not deliver the investment return required and it gets confused by what a pension can do (Can it be flexible, be used for IHT etc..). Clearly it can’t do all these things and pay a lifetime income, infact drawdown can’t even guarantee a lifetime income. It will need a product that isn’t around at the moment – a deferred annuity for a float and fix arrangement. 

Whether people really want float and fix is open to question, I think they want a pension when they set out, that’s what I want anyway! Let’s see if we can do a little better than we have so far. Let’s give people some protection against living too long to those who don’t have confidence they’ll get float and fix right!