Updated 13 March 2018
Ever wondered what the retirement of the future will look like? You should do, because it probably includes yours. Gary Jefferies, director of H&D Wealth (tw) Ltd, reveals how pension freedom has created a whole new world of opportunities – and real risks.
Pension freedom has given all of us more choice about how we plan our retirement. But as is often the case, if your options are greater, you also need a greater understanding of what’s available, so that the choices you make are suitable.
Before April of this year, options were relatively simple. You would have either a final salary pension scheme (which paid a guaranteed retirement income for life) or a money purchase scheme, in which a pot of money was invested throughout your normal working life. Upon retirement, it was usually assumed that you’d use this pot to buy a pension annuity, which would pay you an income for the rest of your life.
However, since the arrival of pension freedom, far fewer people in the UK have been purchasing annuities. A number of factors are behind this fall from grace: the current low level of annuity rates, their limited flexibility and their vulnerability to inflation – for although you can fight inflation with an annuity that increases over time, most people choose not to take this costlier option and prefer a higher starting level instead. Finally, just having a viable alternative to annuities is enough to lure many people away from them.
The main alternative, drawdown, is refreshingly different. But different doesn’t necessarily mean better.
If you take the drawdown option, then instead of using your pension pot to buy an annuity, you leave the money invested (in a specially designed fund) and draw an income from the savings and the growth on them. This option has actually been around for a long time, but was previously available only to individuals who could confirm they also had a guaranteed retirement income of £12,000 a year for life (e.g. from a final salary pension or an annuity). Now, however, it’s up to you to decide whether you want to take on the risks of drawdown.
The flexibility of drawdown is part of its allure. The danger is falling for its attractions and failing to understand the downside. Most people underestimate how long they are likely to live (life expectancy is rising all the time) and so feel they can spend more their earlier years of retirement than is actually prudent. Drawdown funds can dwindle rapidly once you start to eat into the capital sum, so with this approach you may well run out of money long before the end of your retirement.
Think you can do better?
The big selling point of drawdown is that you get to choose how much to pay yourself each year. That is also its biggest challenge. Working out what is a sustainable level of income is a problem with which annuity providers have been grappling for years – so whether or not drawdown is a better option for you depends largely on whether you can estimate this figure more accurately. Before charges, and assuming a diversified portfolio, you would generally need to keep withdrawals at around 4 per cent per annum in order to make the fund sustainable. In most cases, this won’t be enough money to meet your retirement income needs. But if you withdraw higher amounts then the fund may soon become unsustainable, and expire before you do.
Risk-taking in retirement
If your drawdown fund is to be effective, it needs the opportunity to grow. This means including a high proportion of asset-backed investments such as shares and commercial property, which are also generally higher risk. So you will continue to take investment risks well into retirement, and will also need to monitor your funds on an ongoing basis. You will need to ask yourself if you can see yourself continuing to do that as you get older. Here is perhaps another seldom-considered advantage of the annuity: it’s a one-off purchase with no ongoing maintenance involved.
If you’re contemplating drawdown, you will probably need to prepare for it long before you actually retire. This is because, traditionally, an invested pension pot would be moved into low-growth, low-risk funds in the years leading up to retirement, in order to avoid any sudden dips just before annuity purchase. But if you’re planning to invest the money in a drawdown fund, then this would call for a completely different investment strategy during those years, one that provides continued growth as well as preserving the capital. In other words, it pays to think ahead.
A new kind of retirement
Perhaps some of the gloss has come off the drawdown option. But with annuity rates still low, the dilemma remains. Which do you choose? The surprising long-term answer may turn out to be: both.
Pension freedom is likely to encourage new modes of retirement. No longer do you have to make a fixed and final choice at the age of 65: you can, for instance, start with a drawdown scheme and then buy an annuity later, or buy annuities in tranches as your income needs and lifestyle change over the years.
Indeed, the exact point of retirement has been blurring for a while. There is a rising trend (known as ‘partirement’ in the US) of continuing to work reduced hours after retirement age, which pension freedom is likely to make even more practical and attractive. In addition, people may increasingly turn to equity release mortgages to supplement their retirement incomes, releasing value from their costliest asset, their home.
One thing is clear: retirement is suddenly full of new and interesting possibilities. How we reinvent it will be up to us, but everyone can increase their chances of a comfortable and sustainable retirement by talking to a financial adviser sooner rather than later.
Gary Jefferies is a Chartered and a Certified Financial Planner with over 30 years’ experience. He advises clients on both pre- and post-retirement planning and firmly believes that the new options afforded by pension freedom will allow individuals significantly more flexibility and control over their retirement.
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