Squeeze more income from your pension
If you're coming up to retirement age and have been wondering how you'll fund the next 25 years on your shrunken and battle-scarred pension fund, you probably have cause to feel a little more positive than of late.
Indeed, the recent market recovery has encouraged many people, who had decided to shelve retirement until their pension pots looked healthier, to bring their plans for retirement forward, according to Nigel Callaghan, a pensions analyst at Hargreaves Lansdown.
"Their funds haven't recovered fully back to their October 2007 levels, but people are fearful of the market slipping back again so they're cashing in at least some of their pension now," he explains.
Often, retirees will continue to work in some capacity and use the additional income as a supplement.
There are several key considerations if you're planning to draw some or all of your pension. It's useful to assess the parameters of your retirement: what are your circumstances and plans?
What do your total assets (not just your pension) amount to and where are they invested? What are your outgoings likely to be? How comfortable would you be with an element of investment risk hanging over your income?
By assessing these considerations you're then in a stronger position to weigh up the suitability of the various retirement income options available.
These range from the security of a fixed lifetime income to the flexible but potentially vulnerable alternative of income drawdown direct from your invested pension pot - now known as an unsecured pension or USP.
Whichever option you select, you are allowed to take up to 25% of your pension pot as a tax-free lump sum when you cash it in, which could be useful for clearing your mortgage or other debts, but may also be a useful means of supplementing your non-pension income, as we'll see later.
Given the range and complexity of possibilities available, and the significance of your decisions, it makes sense to talk to an independent financial adviser (IFA) to ensure you're structuring retirement income plans in the best way for your needs.
Lifetime annuities - the traditional retirement income - pay a fixed or rising income for the rest of your life. They promise absolute certainty, regardless of collapsing stockmarkets or shrinking interest rates and they'll go on as long as you do.
On the downside, they are inflexible and when you die the remaining capital is lost to your estate.
Nonetheless, for most people an annuity is the only viable option, as they cannot afford to gamble on a fluctuating income that is reliant on investment performance.
Even if you have only a small pension - the average pot for UK retirees is around £26,000 - you have some important choices to make. But most people don't bother to make them.
Around 90% of the 500,000 people who retire this year will buy a lifetime annuity and 60% will simply take the income offered by the pension provider holding their pension fund.
This annuity is unlikely to be a market-leading rate because big insurance companies know they have that ready-made customer base who'll take whatever is offered. Don't be a part of it.
There are online comparison sites and supermarkets such as the Annuity Bureau, or you can use an annuity broker or independent financial adviser (IFA).
The difference between the best and worst level (unchanging) annuity rates is around 20%, according to Hargreaves Lansdown's Callaghan.
Do you want an escalating income?
These annuities will increase year-on-year by a set percentage (say 3%) or in line with inflation.
The catch is that, at the start, when you're more active and likely to need more income to fund your lifestyle, the initial income is considerably lower than for a level annuity (around 37% lower for a 65-year-old man, according to Alexander Forbes Annuity Bureau).
"It can take up to 20 years before the escalating rate catches up, so people are not better off than if they had taken a level annuity until they reach the age of 85 or so," says Daniel Clayden of IFA Clayden Associates.
Most people want the money upfront so choose a level annuity. However, the impact of long-term inflation may be more of a worry if you're retiring young.
Enhanced rates for impaired health
It may feel counter-intuitive, but this is the one time in your life when it's worth pushing your health problems to the fore because you could get a larger annuity income.
"If you're a smoker, take regular medication, or have been hospitalised in the last five years, it's worth looking at enhanced annuity rates even if you don't consider yourself remotely sick," says Clayden.
You may also qualify for enhanced rates if you have a combination of relatively mild conditions such as weight issues and mild diabetes, if you live in certain postcode areas, or have had a dangerous occupation, which could impact on your health later.
"The uplift depends on the severity of your condition, but it can be anything from 10% to 50%," he adds.
Even if you want the certainty of an annuity, you don't have to use all your pension pot at once, if it's big enough to be worth splitting. "Retiring investors are becoming a lot more sophisticated about their pension arrangements," Callaghan explains.
"Most still buy a one-off annuity" but many people with larger pension amounts have worked out how much they need to cash in at this stage, given their circumstances.
"They are splitting their pension pot into chunks and buying a series of annuities over several years."
By doing so, it's possible to gain financially in several ways. First, your pension fund may continue to recover and grow. Second, annuity rates may rise. Third, the older you are the higher the annuity rate.
Fourth, if your circumstances change in the intervening period - for example, if you develop a chronic condition, or you have a joint annuity but your spouse dies, you may qualify for a different type of policy that pays more.
Against this is the risk that annuity rates may fall in the interim. As Dave Harris, a director at annuity provider Primetime Retirement, observes: "The quantitative easing programme has pushed down gilt yields [on which annuity rates are based] to an all-time low and some commentators are saying they're likely to rise."
But even if rates do decrease, there's an argument that other factors pushing your rate up are likely to outweigh any fall.
The leading question is how you make ends meet in the interim. Again, people are being increasingly creative in combining pension and other incomes. More continue to work in some capacity beyond retirement age.
Others have a lump sum - from savings, an endowment policy or inheritance - which they draw down as income.
They may also use the tax-free cash available on each chunk of pension (up to 25% of the sum withdrawn from the pension fund) as income. Or there may be non-pension investments that can be used to generate an income.
It's a simple enough idea - a more flexible variation on the DIY-staggered pensions discussed previously.
Rather than locking yourself into a lifetime annuity, you can use your pot to buy a fixed-term annuity offering the same investment security but running for a specified number of years, as well as a maturity amount at the ned of the specified period (typicallly five).
At the end of the term you receive your fund back, minus the income payments made, and reinvest it in the most appropriate product for your current circumstances.
These offer a halfway house (or third way) between annuities and USPs: basically, you leave your pension fund fully invested and take an income under drawdown rules, but there is a guarantee option to protect you from market crashes.
Providers in the UK include Lincoln, MetLife and Aegon. A fourth player, Hertford, pulled out of the UK when its US parent hit funding problems in the credit crunch.
Income drawdown with a safety net sounds an attractive proposition. Simon O'Connor, Lincoln's head of marketing, points out:
"The last 12 months have brought home the value of variable annuities, and of staying invested so that your pension fund can recover from market downturns but has a guarantee to protect your income."
However, criticisms have been widely levelled at the market. "We like the idea of a third way, but we dislike the complexity and cost of these products.
When you look at the component parts - guarantee, administration, underlying investment costs, IFA commission - the investor could be paying 3% to 3.5% a year. If you draw a 5% income, that's an 8% growth hurdle to meet just to stand still," says Callaghan.
"There's definitely a gap in the market, but the problem is the cost of securing the guarantees," adds Martin Palmer, head of corporate pension marketing at Friends Provident.
"Also, they're not transparent and there have been concerns about the robustness of the hedging process. It's not an area we're considering at the moment."
Unsecured pension (USP)
This involves leaving your pension fund invested and drawing an income from it. Clearly, the potential risks and returns of exposure to the markets remain.
But you have much more control over the amount of income you draw, and another big attraction is the fact you can leave the remaining fund to your partner, subject to a 55% tax charge.
ASPs allow your funds to remain invested, but there are stricter regulations on the levels of income that can be taken or what happens to the remaining capital when you die.
"You need a pension pot of at least £125,000 or £150,000 before you can consider income drawdown,' says Keith Churchouse, director of IFA Churchouse Financial Planning.
"However, it can make particular sense as an alternative to an enhanced annuity for people in poor health because they can leave their pension fund for the family."
USPs also appeal to entrepreneurs, says Neil Merryweather, a director at Rowanmoor Pensions. "They've built up wealth and the idea of writing a cheque for an annuity income is anathema.
They like the flexibility of USPs, particularly as they often have wealth built up in several places as well as their pension."
So where income from other sources is unpredictable, the level of USP income can be fine-tuned as necessary. It's possible to take your 25% tax-free lump sum and leave the rest of the fund fully invested if you don't need an income at all to begin with.
It's also possible to mix and match annuities and USPs. "One option is to buy an annuity big enough, in combination with the state pension, to cover the monthly bills so you have a secure bedrock and can supplement that with income drawdown,' says Merryweather.
As well as tax wrappers, says Merryweather, retirees shouldn't forget about their capital gains tax (CGT) allowance. "If you hold a portfolio of growth-oriented unit trusts or Oeics, for instance, you can cash in up to £10,900 of gains in this tax year without broaching your allowance."
And even if your capital gains exceed the allowance, it's better to pay 18% CGT than income tax at 40%.
This article was originally published in Money Observer - Moneywise's sister publication
A financial adviser who is not tied to any financial services company (such as a bank or insurance company) and is authorised by the Financial Services Authority (FSA). They can advise on financial products to suit your circumstances. All IFAs have to give consumers the choice of paying by fees or commission and have to explain which would best suit the customer in that particular instance. Also, if commission is paid either by the client or the financial service provider recommended by the IFA, the IFA must disclose what that commission is.
Open-ended investment companies are hybrid investment funds that have some of the features of an investment trust and some of a unit trust. Like an investment trust, an Oeic issues shares but, unlike an investment trust which has a fixed number of shares in issue, like a unit trust, the fund manager of an Oeic can create and redeem (buy back and cancel) shares subject to demand, so new shares are created for investors who want to buy and the Oeic buys back shares from investors who want to sell. Also, Oeic pricing is easier to understand than unit trusts as Oeics only have one price to buy or sell (unit trusts have one price to buy the unit and another lower price when selling it back to the fund).
Tax-free lump sum
An inelegant phrase that is nonetheless accurate in what it describes: a one-off payment to a beneficiary that is free of any form of taxation. Usually received when using a pension fund to purchase an annuity, as 25% of the overall fund can be taken as a tax-free lump sum.
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.
Lower interest rates encourage people to spend, not save. But when interest rates can go no lower and there is a sharp drop in consumer and business spending, a central bank’s only option to stimulate demand is to pump money into the economy directly. This is quantitative easing. The Bank of England purchases assets (usually government bonds, or gilts) from private sector businesses such as insurance companies, banks and pension funds financed by new money the Bank creates electronically (it doesn’t physically print the banknotes). The sellers use the money to switch into other assets, such as shares or corporate bonds or else use it to lend to consumers and businesses, which pushes up demand and stimulates the economy.
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).
Capital gains tax
If you buy an asset – shares, a second home, arts and antiques – and then sell it at a later date and make a profit, that profit could be subject to CGT. You don’t pay CGT on selling your main home (which is why MPs “flipped” theirs so regularly) or any securities sheltered in an ISA. Individuals get an annual CGT allowance (£10,600 in 2010/2011) but if you have substantial assets it’s worth paying an accountant to sort it for you.
A contract written by a life assurance company to pay a fixed sum (“the basic sum assured”) to the assured person on a fixed date in the future or to their estate should the person die prematurely. The policies normally run for five, 10, 15, 20 and 25 years. Monthly premiums are calculated on the age of the life insured, the basic sum assured required at maturity and the length of the policy, so each policy is unique. The policies can be with-profits or unit-linked (see separate entries). A common investment product during the 1980s, endowment policies were sold alongside interest-only mortgages and designed to provide enough money to repay the capital borrowed at the end of the mortgage term. However, mis-selling scandals and poor investment performance discredited endowments as a mortgage repayment method.
Everything you own: all your assets (property, cars, investments, savings, insurance payouts, artwork, furniture etc) minus any liabilities (debts, current bills, payments still owed on assets like cars and houses, credit card balances and other outstanding loans). When you’re alive this is called your wealth; when you’re dead, it becomes your estate.
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.