How can you plan your income for the next twenty-five years or more when you don’t know what next week will bring? What price security in such a fast-changing world? Pensions expert Billy Burrows returns with insights to help you take back control.
What’s the best way to take an income from your pension? Last year I brought you a pair of articles with some serious number-crunching, to help you compare the benefits of an annuity versus a drawdown scheme. I concluded that, with interest rates so low, you’d need only a 2 per cent investment return for your drawdown plan to beat an annuity.
So why ask the question again? Because the pension world is like the UK weather – it changes. And lately we’ve seen a huge amount of economic ‘climate change’ in the world that could alter the landscape for retirees even more.
Three choices – countless possibilities
April 2017 brings the 2-year anniversary of pension freedom. Most people should be aware by now that from the age of 55 you can access your pension pot in one of three ways:
- As a cash lump sum (minus tax at your marginal rate)
- By purchasing an annuity (a guaranteed income for life)
- By investing in a drawdown plan (regular and flexible income paid directly from your pension pot)
On the face of it, a simple set of choices. But determining which one is best for you is one the hardest questions in personal finance. It’s also one of the most important, since it will affect your income level for the rest of your life (and even the size of the legacy you leave behind).
But getting it right has become even trickier lately, due to us now living in ‘interesting times’. Many of our established beliefs and assumptions are being challenged, and one of the battle cries of the Brexit and Trump campaigns was ‘Don’t trust the experts!’ How well this approach will pan out in the world of geopolitics, I don’t know. What I do know is that it’s a very bad move where pensions are concerned. Acting on poor information or a ‘gut feeling’ could lead to some very costly decisions.
Balancing ‘What I want’ with ‘What I need’
What’s important to grasp is that there are two forces at work here. Firstly, the behavioural factors which affect the way you personally think of retirement. Secondly, there are the technical factors which impact on the choices you make. So one of the key benefits of consulting an expert is that they can help you bring these two aspects together, and understand the interplay between them.
Time for a table!
How much cash / income
I want as much income as possible and as soon as possible!
You may live longer than expected and run out of money.
I think annuities are ‘poor value’. Also, when I die there’s nothing left for my family.
Annuities are the only way to guarantee an income for life.
How much flexibility and control?
I want the freedom to control my income and leave money to the family.
Flexibility of income may increase the risk of a lower income in the future.
Drawdown seems to deliver better returns than an annuity and the stock market is doing well!
Drawdown has a number of technical risks including ‘sequence of returns’ risk and ‘mortality drag’.
As you can see, the table brings together some of the main behavioural and technical issues that you will have to grapple with. I will be covering these issues in more detail in my next article, but now it’s time to take a look at how external events may have an equally significant impact on your retirement decisions.
Retirement planning in an uncertain world
When it comes to long-term financial planning, the three most influential factors are inflation, interest rates and the stock market.
Inflation has been very low in the UK for some years. The Bank of England has steered the economy towards 2 per cent inflation, but there are signs that inflation is on the way up as a direct result of Brexit. A weaker pound means that goods imported from abroad are more expensive, and this has increased prices for customers.
In the short term it is easy to miss the effects of inflation, but those on a fixed income are the most affected. For instance, the spending power of a level annuity would be halved in just 15 years if inflation was running at 5 per cent per annum. In short, if inflation is set to rise it will become even more important to consider ways to protect your retirement income from its effects.
Interest rates have likewise been very low for year, and although there is no reason to expect them to shoot up in the short term, rising inflation increases the likelihood of future rises. If interest rates rise this will result in higher annuity rates (a good thing), but don’t hold your breath – it’s likely to be a slow rise over a relatively long period.
Predicting the stock market is about as easy as guessing next month’s weather. At the time of writing it continues to be rising healthily, but many financial commentators are expecting trouble ahead, stemming from the twin unknowns of Brexit and the economic policies of a USA under Donald Trump.
So the big question remains: if we can expect turbulent times ahead, what defensive action should we be taking now?
A foot in both camps?
Many people have treated the annuity vs drawdown debate as a black-and-white choice. However, they can easily be seen as partners rather than opponents. In uncertain times, it may make a lot of sense to keep a foot in both camps, and use both kinds of income according to your needs and attitude to risk.
After all, when you invest you probably don’t put all your money into risky investments such as shares, and neither do you keep it all in safe but low-growth gilts or cash. The same kind of balanced approach can work well for retirement income. Talk to your financial adviser about both options and see if a combined approach could deliver both the flexibility and the security you’re looking for.
Billy Burrows is an independent retirement options expert and industry commentator. Find out more at www.retirement-iq.co.uk.