the Old Age Pension was introduced in 1909 and at the time the average life expectancy was 48 however the pension wasn’t paid until age 70!
I’m fascinated by the debate on how individuals provide an income when they stop working (whether partially or totally).
In a space of less than forty years a lot has changed.
According to a report in the Telegraph; in 1963 £1 in £4 of all pension savings in the private sector came from guaranteed pension schemes, by 1979 this had increased to £9 in every £10. Gradually we saw this reverse as legislation made the arrangements more costly, investment returns made the schemes unaffordable and life expectancy meant people were living longer.
To reduce costs employers switched to schemes offering no guarantees and income was based solely on investment returns on the retirement pot. Of course people looking to take an income cry foul today because what they could have got for their pot fifteen years ago is different to what they could get today. There are many factors to consider but one simple factor is this…we are living longer.
Beresources.co.uk highlights that the Old Age Pension was introduced in 1909 and at the time the average life expectancy was 48 however the pension wasn’t paid until age 70! Today it is moving to age 68 at a time where average life expectancy is 81 and rising (source worldbank.org).
In simple terms when the state pension was first introduced very few people were expected to ever reach it, therefore the cost of providing it was affordable. As life expectancy improved the cost increased, and there would have been a tipping point where it was not affordable but only now are the government doing something.
This applies to getting an income from a pension pot. It is not possible to provide the same income as 15 years ago because the chances are that we will live longer (in 15 years life expectancy has increased by 3 years (source worldbank.org)). So the income drops but in theory lasts longer.
So what does this all mean? In this blog we want to look at a piece of research provided by Jeannie Boyle of EQ Investors (eqinvestors.co.uk) as this highlights some significant challenges for people looking for an income and retiring.
The rise of uncertainty
Until recently anyone approaching retirement had a ‘simple’ choice buy an annuity or take drawdown (awful phrases because many don’t really understand what this means).
So what do they mean?
An annuity is basically being given a guaranteed income for life in return for a sum of money. To explain further, I give company XYZ £100,000 and in return they give me £400 a month for life.
If I die after just one payment then the income stops with me. That means effectively I have lost £99,600 and company XYZ have gain £99,600. (If I live for 20 plus years then in theory the investment favours me).
But of course protection can be built in, payments can be guaranteed and if you are married then the income can continue to be paid to your spouse. But with each option the income you receive comes down.
On the other side was something considered very risky – drawdown…effectively rather than giving the money to someone and asking them to guarantee an income you kept the money and drew an income from this. But there were restrictions on the amount of income to ensure you didn’t run out of money.
Now something radical has happened, to address a changing environment we can effectively do what we want with our pension fund. If we want to we can take the whole fund as a lump sum (subject to tax), we can take any income from our pension fund or we can buy an annuity.
Unsurprisingly as highlighted by Jeannie and using figures from the Association of British Insurers annuity sales have fallen dramatically – from 74,100 in Q1 2014 to 20,600 in Q1 2015.
This doesn’t necessarily mean people have switched to drawdown but it is likely some will have. The risk of drawdown has not changed, if anything it has increased with the different options, and yet it appears that people are favouring this route. (And not forgetting it forms part of your estate for inheritance tax).
The risks of drawdown – option 1
The headline for everyone is taking the fund as cash.
For example, you have a pension fund of £100,000. You can receive £25,000 tax free and you take the rest as a lump sum.
This is generally subject to tax at 40% meaning £100,000 is now worth £70,000. In one move you have lost £30,000.
Put this another way you have to make a 42% return on that investment (after tax) to bring it back up to the original £100,000…crazy put true.
The risks of drawdown – option 2
Jeannie highlights the risk of drawdown that many seem to have forgotten. Simple put “using drawdown means accepting investment risk into your income decisions.” Jeannie goes onto to explain something she calls ‘pound cost ravaging’:
“If you have set up a regular withdrawal from your pension fund it’s likely some units will be sold on a regular basis to provide your income. When markets fall, more units will need to be sold to provide your payments. But when markets recover, you have fewer units to benefit from the uplift. This is called ‘pound cost ravaging’.
The following graph shows a pension fund of £100,000 and annual withdrawals of £5,000 increasing at 2.5% each year. The pink line assumes growth is steady at 5% each year and tells us the fund would be exhausted after 28 years.
The grey line assumes negative returns of 3% for the first year, with 5% thereafter. A further negative correction of 3% in year 17 is also factored in. For this example, the fund only lasts for 26 years. These figures are only provided for illustration purposes. In reality returns each year will vary and you are very unlikely to experience such smooth returns.
If the client in the second scenario did not have additional resources to provide income, they could be significantly disadvantaged in later life. If £100,000 was used to purchase an annuity with annual increases of 2.5%, the starting income would be £4,429 (including a 5 year guarantee period, but not a spouse’s pension). Anyone with a health condition could potentially benefit from a better annuity rate.
For anyone who is unhappy with investment risk or does not have additional resources from which to cover their expenses, securing an annuity might mean a slightly lower initial income, but overall may be a more appropriate option.
The choice of whether or not to purchase an annuity or use income drawdown does not necessarily need to be an either or decision. But equally a pension fund is not the only source of income (ISA income can be tax free, state pension etc).
It is about understanding in advance what you have and what you need and then considering the best way to achieve this. Considering what you need is not just about the income you need but also whether you want it to be passed onto your family after your death.
But as Jeannie explains it goes a little further.
Don’t put all your eggs in one basket
Investors have to accept that going forward returns will be lower. The Barclays Gilt Study in 2013 estimated that returns from bonds would be around 2% p.a. and equities 5% after fees in the coming years. This means that investors need to be more realistic on the income they want and how they achieve it but as Jeannie explains.
“For retirees reliant on the income from their pension pot to cover regular expenses, a diversified mix of investments will help to protect against the effects of pound cost ravaging. When one part of the mix is doing badly, other parts may be doing well, meaning the timing of withdrawals is less significant.
The current market turmoil highlights the importance of regular reviews of your financial situation. An annual review that includes cash flow modelling is extremely useful for anyone unsure about how much income they can expect from their investment plan.
It is not just about getting the right mix of investments it is also about being realistic about the levels of income and continually monitoring your investments (cash flow modelling).
The way we receive income in retirement has changed significantly and the choices we make are much harder than we think. Even buying a guaranteed income comes with challenges. The key to all of this is understanding what we want, planning and continually reviewing. Pension freedom is not necessarily the best thing to happen, it brings risk and a need for greater responsibility.
Source: The information for this blog has been sourced from various places. The key sources include; article by Jeannie Boyle, Technical Director at EQ Investors, worldbank.org data on life expectancy, beresources.co.uk article on pension auto enrolment and Telegraph article ‘Final Salary and the death of pensions the world envied’.
Note: This is written in a personal capacity and reflects the view of the author. The post has been checked and approved to ensure that it is both accurate and not misleading. However, this is a blog and the reader should accept that by its very nature many of the points are subjective and opinions of the author. This is not a recommendation to buy any product or service including any share or fund mentioned. Individuals wishing to buy any product or service as a result of this blog must seek advice or carry out their own research before making any decision, the author will not be held liable for decisions made as a result of this blog (particularly where no advice has been sought). Investors should also note that past performance is not a guide to future performance and investments can fall as well as rise.