Is there a future for pensions?
If you're retiring in the coming months, you may well be wondering how you're going to make ends meet once you stop work. First, pension pots have been damaged by stockmarket volatility of recent years. Then there's the problem of record low yields on government bonds (known as gilts), which influence the amount of annuity (lifetime income) your pension will buy - so annuity rates continue to shrink.
And even if you have a large enough pension pot to consider income drawdown, which involves leaving your pension fund invested and taking an income directly from it, you've been hard hit: the amount you're allowed to take has shrunk anyway with falling gilt yields, and been further limited by recent government restrictions reducing the amount of drawdown that can be taken each year.
To cap it all, inflation is running at 4.2% (consumer prices index) - steadily eroding the value of retirement income - while any non-pension savings held in the bank are likely to be earning less than inflation and so also losing value in real terms.
Given the UK's ageing population as the baby-boomer bulge approaches retirement age, plus our improving health and life expectancy, some radical rethinking is clearly needed around the whole issue of how we're going to manage financially.
We need change now
Last month, we looked at how the government might encourage people to save more for retirement in the long term. But there are various factors that could help in the shorter term, including a truly ‘open market' for when it comes to arranging a retirement income; better education about pensions; people recognising the need to ‘take ownership' of their financial futures in a way that many don't now; and new, more flexible retirement income products.
But grassroots change, as ever, is painfully slow. Here, we take a look at the various options and strategies that could help ensure you're better off if you're retiring in the near future.
If retirement is upon you now or fast approaching, there is little hope of a miraculous turnaround in circumstances. With UK pension pots averaging just £25,000, annuities are the only option for most of us. But falling annuity rates mean a 65-year-old man with a pension fund of £100,000 will now receive an income of only £5,600 a year (and it's not inflation protected) – down from £6,500 in July this year.
So should you defer in hope of growth in your pension fund or a pick-up in annuity rates as and when gilt yields rise again? It's a big risk, says Jim Boyd, director of corporate affairs at specialist annuity provider Partnership. "The major risks of not locking into an annuity now, however rotten the rate may seem, are first that annuity rates may have got worse by the time you fi nally purchase one, and secondly that the value of your fund may fall."
Indeed, Bob Bullivant, chief executive of retirement planning specialist Annuity Direct, believes planned changes in regulations mean there's little likelihood of annuity rates improving in the foreseeable future.
"Rather than deferring, it's more important to buy the right kind of annuity, considering your health and circumstances, looking across the whole market," he says. Historically, however, many people coming up to retirement have been quite happy to flop straight into the mediocre annuity rate offered by their pension fund provider - all too often losing out on many thousands of pounds of lifetime income in the process.
There has been some industry effort to push people towards the open annuity market. For instance, the Association of British Insurers (ABI) no longer allows its members to include annuity application forms with the information packs they send to customers approaching retirement. But, says Bullivant: "I've yet to meet anyone who thinks the ABI has gone far enough."
Our three-point pensions manifesto
In light of the continuing pension gap and the increasing challenges facing people attempting to fund a comfortable retirement, Moneywise and its sister title Money Observer call for a more enlightened approach to pension income in the following respects:
1. The government and the Financial Services Authority should take action to ensure that all pension holders select their retirement income from the open market as a matter of course, and that they are able to access affordable, independent guidance as part of the process.
2. The pensions industry should further develop innovative retirement income solutions to suit pensions of all sizes, with the emphasis on both security and income flexibility.
3. Government and industry should work to establish a more flexible, user-friendly approach to retirement saving that takes into account both ISAs and pensions.
WE MUST TAKE RESPONSIBILITY
Ultimately, it's still up to the individual to take responsibility and shop around. But it's not just a matter of looking for the best rates, though these may beat the worst by as much as 20%.
You should look at getting the best form of annuity for your circumstances: single or joint? Paying a rising level of income over the years to help against inflation?
You should also look at ways of enhancing the income: do you have any health concerns or lifestyle issues that may affect your life expectancy? Enhanced annuities average about 20% more than ordinary annuities, according to annuity provider MGM Advantage. Around 40% of retirees could qualify – but many don't realise they are eligible.
It's worth looking also at the more flexible alternatives to traditional annuities that allow you to adjust your income to your changing needs. These take various forms.
Fixed-term annuities last five or 10 years; when the term ends, you can buy another fixed term or conventional annuity at what's likely to be a higher rate, reflecting your greater age and any changes in health or circumstances (maybe your spouse has died), as well as general annuity rates.
There is also a range of flexible investment-linked annuities. A minimum level of income is guaranteed, but investors have to be prepared to take an element of investment risk. Against that, ordinary lifetime annuities are by no means risk-free themselves, as they are likely to be eroded by inflation.
THE IMPORTANCE OF GOOD ADVICE
As the market becomes more complex, seeking professional advice becomes increasingly important. As such, the government must work out how to ensure everyone can access good quality advice, regardless of the size of their pension pot.
Those with larger pensions (typically above £100,000) have the option of leaving their fund invested and drawing an income stream from it. But here too trouble has struck: the maximum amount you can drawdown depends on the Government Actuarial Department (GAD) rate – which, like annuity rates, is linked to gilt yields. As gilt yields have bombed recently, the GAD rate has dropped to a new low.
Moreover, the government has changed the drawdown rules, cutting the maximum annual drawdown from 120% to 100% of a comparable annuity. As a result, Mary Stewart, director of self-invested personal pension provider Hornbuckle Mitchell, explains: "A 65-year-old man with a £100,000 pension fund can now only take a maximum of £5,600 a year from the fund. This compares to £8,400 in March 2011, when gilt rates were higher and before new restrictions were introduced – a fall of a third."
It's also important to take a broad view of your retirement income by combining pension income with that from other savings. ISAs provide the obvious choice of non-pension income for many people. They work well with pensions, because although you pay into ISAs out of taxed income (unlike pension contributions, which get tax relief), they are more flexible than pensions and offer easy access to your money. Better still, ISA income is tax-free, so it won't push you into a higher-tax bracket if you're teetering on the brink, or count towards your personal tax allowance.
Squeezing a decent retirement income out of your pension and savings may not be easy but you can at least make sure you're making the very most out of what you've got.
Tax tips you cannot afford to miss out on
These two simple strategies are often overlooked, but they could make a significant difference to your retirement finances.
- If you're married, make full use of both partners' tax-free personal allowances (£9,490 each for over-65s in 2011/12): "I often see couples where one partner has an income that pushes them well into a higher tax band, while the other hasn't even enough income to use up their personal allowance. You can't transfer pension assets between spouses, but you can transfer other assets to minimise the amount of tax you pay as a couple," says Vince Smith- Hughes, head of business development at Prudential.
- Make sure your national insurance is fully paid up to ensure a full state pension. You're allowed to pay voluntary contributions to top up any gaps left over the past six years. The Pensions Advisory Service has a useful online calculator, pensionsadvisoryservice.org.uk.
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.
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.
A scheme originally established in 1944 to provide protection against sickness and unemployment as well as helping fund the National Health Service (NHS) and state benefits. NI contributions are compulsory and based on a person’s earnings above a certain threshold. There are several classes of NI, but which one an individual pays depends on whether they are employed, self-employed, unemployed or an employer. Payment of Class 1 contributions by employees gives them entitlement to the basic state pension, the additional state pension, jobseeker’s allowance, employment and support allowance, maternity allowance and bereavement benefits. From April 2016, to qualify for the full state pension, individuals will need 35 years’ of NI contributions.
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 familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
Association of British Insurers
Established in 1985, the ABI is the trade body for UK insurance companies. It has more than 400 member companies that provide around 90% of domestic insurance services sold in the UK. The ABI speaks out on issues of common interest and acts as an advocate for high standards of customer service in the insurance industry. The ABI is funded by the subscriptions of member companies.
A type of derivative often lumped together with options, but slightly different. The original derivative was a future used by farmers to set the price of their produce in advance before they sowed the seeds so that after the harvest, crops would be sold at the pre-agreed price no matter what the movements of the market. So a future is a contract to buy or sell a fixed quantity of a particular commodity, currency or security (share, bond) for delivery at a fixed date in the future for a fixed price. At the end of a futures contract, the holder is obliged to pay or receive the difference between the price set in the contract and the market price on the expiry date, which can generate massive profits or vast losses.
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.