The new pension option to boost your retirement income
Most avid Moneywise readers will know that they should not rush straight into buying the first annuity they are offered on retirement because a much better deal will invariably be available if they shop around, particularly if their health is impaired.
What most readers may not know is that there will soon be another option at retirement - to invest your pension pot in a bridging fund that pays an income until you decide what to do with it - and this has many very real advantages.
A key attraction of investing your pot into an income-paying fund for the first few years of your retirement is that you can avoid buying an annuity at the current low market rates.
You can wait until annuity rates have improved, perhaps as bond rates rise, or even until your health deteriorates when you would be able to purchase an impaired annuity offering a much better deal.
A second key benefit is that if you die in the first few years of retirement, your spouse or dependants will receive your remaining fund, a significant factor bearing in mind they would receive nothing if you buy a single life annuity. If the pension is paid to the dependant or spouse as a lump sum, though, it is liable to tax at 55%.
The third advantage is that your fund is invested in the markets for a longer period, enabling it to grow in value and generate more income in retirement. This can transform your future income because your pension pot should be at its largest size at the point of retirement and therefore able to generate bigger returns.
To demonstrate, in final salary schemes, where pensions are paid from a fund that is continually invested, 30% of the benefits are generated from preretirement investment and a massive 60% comes from post-retirement returns.
This is critical because people are living longer. For example, a man retiring today has a 10% chance of living beyond 100. With retirement extending past 20, or even 30 years, it makes no financial sense to force a pension fund to forgo years of potential growth, particularly if in a few years we enter a period of higher inflation.
Other reasons for delay
There are other good reasons for delaying an annuity purchase. In practice, at the time they retire most people actually know little about how the next 20 to 30 years of their lives will pan out.
The statistics on the matter are fairly grizzly. For example, most people enter retirement as one half of a couple but in 60 to 70% of cases, one person outlives the other by a surprising 10 years. Divorce after retirement is also on the increase.
Furthermore, in the first 10 years of retirement you are three times more likely to develop diseases such as cancer, heart problems or dementia that may lead to premature death, than in the years leading up to retirement.
Time to reflect
Buying an annuity is still generally the best option for most investors, providing a regular, guaranteed worryfree income for later years. However, it ties up your money for good, leaving no room for manoeuvre.
Delaying annuity purchase means you should be able to select the plan - joint or single life, for example - that best suits your circumstances.
David Hutchins, UK head of defined contribution investments at Alliance Bernstein, an investment company that plans to launch a 'retirement bridge' fund later this year, says: "Forcing people to make the biggest financial decision of their life in one day is not sensible.
"Pensions are complicated and there are not many role models - the parents of people retiring today may have retired 20 to 30 years ago and are a poor example of potential longevity anyway as people are living so much longer.
"Our research showed that a lot of the time people buy the first annuity they are offered simply because they need an income or paycheck in the next month, and they have not thought it all through."
However, you cannot simply buy a pension bridging fund with your pension pot and take money out at will whenever you need it.
HM Revenue & Custom's quid pro quo for the tax breaks you received on your pension investment is that you do not use it all up prematurely and fall back onto state welfare. There are strict guidelines about how much you can withdraw from your pot every year based on factors such as your age, gender, the size of your pension pot and the current gilt index yield.
Traditional income drawdown arrangements are monitored by specialist pension advisers and the charges can be too high for someone with an average-sized pot.
These new retirement bridge funds, often dubbed as 'pensions drawdown lite' arrangements, are designed to be arranged by employers or by master trust arrangements (pooled pension pots that can be run by trade organisations or investment companies), which even someone with modest pension savings can buy into.
Under a traditional drawdown arrangement run by a specialist adviser, you would typically pay an annual charge of 1%, plus a set fee of perhaps £250 per year, for advice such as monitoring income levels.
In fact, figures from Alliance Bernstein reveal that for the average £25,000 fund the annual fee will actually rise over time to more than 2% by the 10th year as a fund managed in the traditional way is depleted by other charges.
Another important factor is 'mortality drag' - the percentage by which the fund must continue to grow to be able to purchase the same level of annuity as it would have purchased at the investor's retirement date.
Alliance Bernstein calculates for a fund of £25,000, using a traditional charging structure, the mortality drag starts at 0.3% but rises to 1% by year 10. Consequently, the average fund will have to grow by more than 3% per year to achieve any real growth.
Without the traditional high charges, an investor with a £25,000 pot would need only to achieve an annual return of 0.5% over bonds for their fund to grow at a pace at which it continues to purchase the same level of annuity as it could have purchased at the retirement date.
This level of return could be achieved by having as little as 10% in risky assets, Alliance Bernstein claims. However, in comparison, an income drawdown arrangement with a traditional penal charging structure would have to take risky bets with 70% of an investor's portfolio to be able to maintain its annuity purchasing power, something very small investors would not have the appetite for.
New kid on the block
Pension bridge funds are still in their infancy. Providers with multi-asset expertise are considering using mixed asset funds to engineer low-risk funds for bridging owing to the stability provided by the diversification of the assets, although for this purpose they would make a higher allocation to bonds to provide extra security.
Specialists in pension liability-matching are also interested in this market and have low-risk pooled funds that are currently aimed at small pension schemes but could be rolled out to a broader retail market. Standard Life, for example, already offers such funds to employers and pension scheme sponsors for use as their scheme members retire.
Alliance Bernstein's approach is based on a series of pooled low-cost trackers exposed to assets such as shares and bonds that would come to fruition at various dates in the future. It plans to charge no more than 1% for this 'off-the-peg' fund.
It has backtested the fund's performance data over every 10-year period in the past 90 years, and says it would have outperformed on average. It is confident that despite bond yields now at historical lows, there's a high probability of outperformance in the future.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.