Middle-sized pensions: what are your options?
But if you lie somewhere in between, you have some tougher decisions to make.
The average retiree in Britain today has total pension savings of £73,000 when they retire, according to LV=. Until the new pension rules came into force, savers with funds in this region would have invariably purchased an annuity. In 2013 – before the new rules were announced – annuities accounted for 83% of the retirement income market, according to industry figures.
But an annuity is no longer the only option for Middle Britain and in the year since the changes were first announced, sales have halved, according to Hargreaves Lansdown. Rather than having to hand over your life savings to an insurer in return for a guaranteed income for life, savers can now take the lot as cash or leave their money invested and draw an income from it.
The problem, of course, is that no single option is likely to tick all your boxes. While you might feel empowered to take the cash, this could land you with a huge tax bill and leave you with no plan as to how to turn that now significantly smaller pot into an income.
An annuity would give you a guaranteed income for life but you may be disappointed with the level of income you can achieve or struggle to leave your loved ones with an inheritance. Putting it into perspective, that average £73,000 would only buy an income of £4,140 a year.
If flexibility and control is what you're after, you might love the idea of income drawdown but for all its benefits it is high risk. What if you run out of money?
Thankfully, the new rules make it easier to mix and match to build a plan that suits you. In very simple terms, this might mean taking some cash to pay for some of those early retirement expenses – whether that's a new kitchen, a cruise or just paying off some niggling debts – then using an annuity to secure enough monthly income to pay your bills and cover other regular expenses.
Then you can leave any remainder invested (which will hopefully enjoy some capital growth) to cover unexpected expenses or top up your income when your bills inevitably rise. If you don't spend it, you can relax in the knowledge it will pass to your loved ones when you die without increasing their inheritance tax (IHT) bill.
In recent years, annuities have had something of a bad press. Rates have tumbled, while greedy pension providers have been attacked for failing to tell savers they don't have to buy their annuity through them and could get a better deal elsewhere. Throw in the fact any unspent funds go back to the insurance company when you die and it's easy to see why savers have resented buying these plans.
But savers do want security and peace of mind retirement. According to the International Longevity Centre, three-quarters of those aged between 55 and 70 would prefer a secure and guaranteed income over one that can rise or fall – which is currently exactly what an annuity provides. For these reasons, experts believe annuities will remain central to our pension strategies. However, we won't necessarily be tying up our whole pension savings in them.
"Traditionally, people have come to us and said 'I've got £100,000, how much income can you give me?'" explains Andrew Tully, pensions technical director at MGM Advantage. "Now people will be saying, 'I need £200 a month. How much will that cost me?'"
Tom McPhail, head of pensions research at Hargreaves Lansdown, agrees. "It's about identifying how much secure income you've got and how much you need, and then asking how much capital to allocate to secure that shortfall and then leave the rest in drawdown."
Vanessa Owen, head of annuities at LV=, says fixed-term annuities may also come to the fore as an option for retirees who aren't ready to commit to a lifetime annuity. These provide a guaranteed income for a fixed period of time (say, between three and 25 years) at the end of which a guaranteed maturity sum is paid back to you. At this point you can buy another fixed or lifetime annuity or do something altogether different with your cash.
Owen says this makes them a sensible option for the growing number of people who are planning a phased retirement. "People are approaching retirement in a state of flux, so fixed-term annuities are ideal. People might still be doing some work or deferring the state pension to get a better deal long term. This sort of annuity can provide an additional income for any shortfall before you fully retire."
Alternatively, they can allow you to keep your options open if you expect a long retirement. "If you're in very good health, sadly, annuities don't offer good value," adds Owen. "So a 60-year old could fix for 15 years and then purchase another annuity at 75 and get better value, when statistically they are likely to be in worse health."
The longer the period you are able to fix for, the better the rate you get but Owen says most people still plump for shorter terms, with the average LV= fixed-term annuity just five years. "We can imagine our lives in five years' time and just about 10 but the further out you push, the harder your life is to conceptualise," she adds.
But thinking about the long term is a vital part of financial planning. Inflation will reduce the value of your money over time, so whatever amount covers your monthly bills when you first retire may not stretch far enough in the future. McPhail says: "Over a 20-year retirement, it would not be unreasonable to expect the value of a fixed income to halve."
Your state pension is at least currently protected from inflation by the 'Triple Lock' guarantee and benefits on a final salary scheme may be linked to inflation, too, but your income from other private pensions won't be unless you put plans in place.
You also need to think about how your spending habits will change. Typically, expenditure peaks at the start and end of retirement. Murray Smith, a director at financial adviser Mattioli Woods, explains: "People tend to want more income in the early years and then there are care-home concerns at the other end."
You can work inflation protection into your annuity, so your income increases by a fixed percentage each year or is linked to the retail price index measure for inflation. But annuity providers admit they're costly. "As your salary increased, so you want your annuity income to increase but inflation-linked plans are poor value," says Tully.
An investment-linked annuity allows for your capital to continue growing and, assuming it performs well, should help increase your income over time. Research has shown these plans tend to pay out more than the inflation-linked alternative but, as Tully warns, they're a higher-risk option. "With investment-linked annuities, your money can go down."
Although investment-linked annuities and fixed-term annuities may offer more flexibility than conventional plans and offer a better hedge against inflation, they are nowhere near as flexible as income drawdown.
Income drawdown lets you choose how much income to take and you can change this as and when you need. However, if you don't need a regular income – say, that's covered by part-time wages, an annuity or final salary income – you don't have to take one and can simply leave your money invested for capital growth. This money is then available if your expenditure increases or you need ad hoc lump sums. Should you die without spending it, you can then pass it on to your loved ones.
"Drawdown is a good way of building inflation protection, particularly if you limit yourself to taking the natural yield [your profits] of say 3 to 4%," says McPhail.
But however flexible income drawdown might be, it's risky. Working out how much money you can afford to draw down is tough even for qualified IFAs.
As soon as you start drawing down more than the natural yield of your investment, you start eating into your capital and as soon as your capital starts to shrink, the less income it's able to generate. And this is all before you take into account the risk of stockmarket falls, which could leave you with a major dent to your capital.
"Income drawdown is only suitable if you have a good understanding of investment risk and are comfortable with the risks," suggests McPhail. You also need to be prepared to manage your portfolio yourself – which might not be advisable if you have no experience of buying and selling funds – or pay someone to do it for you.
Indeed, one of Smith's biggest concerns is that investors won't realise how important it is to keep tabs on their portfolio. "There is no formality around monitoring drawdown. It's all about sustainability and making sure you don't run out of money." A good IFA will monitor your portfolio and conduct regular reviews but if you're on your own, you'll need to do that yourself.
There's cost to consider, too. While the cost of drawdown will continue to fall as demand for services inevitably rises, it's still a cost that will eat into your returns. "Even if you're running your plan as cheaply as possible, you're still looking at 0.5% to 1% a year – and that's with very little trading," warns McPhail.
So for all the benefits of annuities and drawdown, both have limitations that could mean they're not the perfect solution for you – even in combination. However, some new products and developments are emerging that providers hope will help retirees strike a better balance of security and flexibility.
Combining a annuity with investing
In May last year, AXA Life Invest launched a guaranteed income drawdown plan. "It combines insurance with investing," says managing director Simon Smallcombe. "It offers a guaranteed income without handing over all your money to an insurance company."
For those who don't want to run their investments, the product offers a choice of four different portfolios to select, each with varying degrees of risk. But for most savers, the crucial question is what sort of income can you expect. "We're currently paying a rate of 4.25% on the initial sum invested, whereas an annuity for a 65-year-old would be around 5%," explains Smallcombe.
This means they will provide significantly less income than an annuity but you would have the benefit that you haven't surrendered all your capital so any remainder can pass to your beneficiaries when you die. "Also if your fund grows, your income will, too, and once it has risen it can never fall," he adds.
Yet peace of mind comes at a price. The basic drawdown plan charges 1%, the guarantee is optional and costs between 0.95% and 1.5% on single life plans or 1.4% to 1.7% if you opt for a joint-life plan, depending on where your money is invested. Then, as the product is only available from IFAs, you have their fees to consider.
Jonathan Watts-Lay, a director of Wealth at Work, says you need to consider how much you're prepared to pay for any guarantee and ask is it worth the price.
His firm manages portfolios for clients with around £75,000 upwards. With advice and underlying investment charges, you would be looking at paying roughly 1.5%.
At the other end of the spectrum, Just Retirement is developing a plan that will enable retirees to combine conventional annuities with a very basic form of income drawdown. It has built a new platform that will enable customers to buy an annuity and leave some capital invested in low-cost tracker products (funds that mirror the performance of specific indices such as the FTSE 100).
As such, the plan should not be costly to run. Stephen Lowe, a director at Just Retirement, explains: "It's about keeping money for a rainy day rather than generating a monthly income." He adds: "For Middle Britain, with modest pension pots, traditional income drawdown is not an appropriate way of generating an income."
However, while you don't have to choose one option, you equally don't have to juggle them. Watts-Lay says for many people retirement will no longer be about making one lasting decision the day you retire. You can keep your options open and start with one strategy and then switch to another as and when your needs change.
"People will make a series of decisions, buying products for a limited time, like they might have done with fixed-rate mortgages on their home," he explains.
Many retirees, for example, might start retirement with income drawdown, enjoying its flexibility, and then switch to an annuity once the peace of mind provided by a secure income becomes more important and their age or state of health means annuities offer better value.
"You might hit your 70s in good health and feel the need to secure an income for life," says Watts-Lay. "Alternatively, you may have health problems that could see you live anything from five to a further 20 years and see the benefits an enhanced annuity could bring."
Before making any decision, you need to take all of your money into account, such as any Isas or other investment plans you might have. You also need to consider your partner's assets, if you have one.
By shifting some assets into your partner's name, you may be able to increase the level of income you can take before you pay tax. Likewise, it may make sense to dip into Isa savings first – which are tax-free – and keep as much money tied up in your pension as long as possible.
With so much to take into account, you may well find it's worth paying for advice. It may sound like another expense you don't need but as the DIY option is hardly cheap (think about less visible costs such as commissions on annuity sales and the cost of managing investments), an IFA might not seem so expensive, particularly once you factor in the price of getting it wrong.
While the options are many for those who have more than enough money to secure the income they need, the fact remains many people will still reach retirement with less than they had hoped for. Savers with modest funds may find the only way they can have enough money to pay the bills will be to buy an annuity as they would have done before the pensions freedoms were introduced.
The pension freedoms give Middle Britain the choice to do what we like with the money we've worked a lifetime to save. The benefits are endless but so, too, is the chance to get it wrong. You may embrace the flexibility on offer or do exactly as you would have done prior to the rule change but, whatever you do, be sure to make an informed decision.
Annuities versus income drawdown: what will work best for you?
|CONVENTIONAL ANNUITIES||INVESTMENT-LINKED ANNUITIES||INCOME DRAWDOWN|
|PROS||Guaranteed income for life||You can vary your income||Your money can benefit from investment growth and you can choose where it's invested|
|No longevity or investment risk||A minimum income guarantee ensures it won't drop below a certain level||You decide how much or little income to take and very it over time|
|Payments can be guaranteed for a fixed period||Payments can be guaranteed for a fixed period||You can leave unused funds for loved ones|
|CONS||Annuity rates have tumbled||Your income could fall if investments perform badly||Your income is not guaranteed for life|
|You may not be able to leave remaining funds to loved ones||You may not be able to leave money to loved ones||You need to choose, monitor and review your investments regularly|
|Inflexible - you can't currently cancel after the cooling-off period||Inflexible - you can't cancel an investment-linked annuity after the cooling-off period||Experts suggest you need at least £150,000 if it represents your main source of income|
Invidivual Savings Accounts were introduced on 6 April 1999 to replace personal equity plans (PEPs) and tax-exempt special savings accounts (TESSAs) with one plan that covered both stockmarket and savings products, the returns from which are tax-exempt. The ISA is not in itself an investment product. Rather, it’s a tax-free “wrapper” in which you place investments and savings up to a specified annual allowance where the returns (capital growth, dividends, interest) are tax-exempt (you don’t have to declare ISAs and their contents on your tax return). However, any dividends are taxed within the investment, and that can’t be reclaimed.
The tax levied on the total value of your estate after you die. IHT has to be paid by the beneficiaries of your estate before they can receive any of the money from it. The money can’t be taken from the value of the estate _– it has to be paid before any money can be released. There is an IHT threshold – known as the “nil-rate band” – below which no tax is levied (£325,000 in 2011/12). Any amount above the nil-rate band is subject to tax at 40%. If your estate totals £600,000, there is no tax on the first £325,000; however your estate will pay 40% tax on the remaining £275,000, a total of £110,000. Prudent tax planning can reduce your IHT liability, so always consult a specialist solicitor.
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%.
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.
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).
The period of time you’re allowed, after signing an agreement, to cancel it without incurring a financial penalty. Financial products including banking, credit, insurance, personal pensions and investments are subject to a 14-day cooling-off period (this is 30 days in the case of life insurance and personal pensions). The insurer or broker must refund any money paid by you within 30 days, although it has the right to deduct a reasonable admin charge, and a sum proportionate to the number of days’ cover you had. If you have any related credit agreements, these will also be cancelled.
A market-weighted index of the 100 biggest companies by market capitalisation listed on the London Stock Exchange. It is often referred to as “The Footsie”. The index began on 3 January 1984 with a base level of 1000; the highest value reached to date is 6950.6, on 30 December 1999. The index is “weighted” by how the movements of each of the 100 constituents affect the index, so larger companies make more of a difference to the index than smaller ones. To ensure it is a true and accurate representation of the most highly capitalised companies in the UK, just like football’s Premier League, every three months the FTSE 100 “relegates” the bottom three companies in the 100 whose market capitalisation has fallen and “promotes” to the index the three companies whose market capitalisation has grown sufficiently to warrant inclusion. Around 80% of the companies listed on the London Stock Exchange are included in the FTSE 100.
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.
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.