For retirees wishing to supplement their annuity income by investing in share, property or fixed-interest products, forward planning is essential as this will ensure a big enough lump sum to give the required flexibility
For many people in retirement an annuity is far from their only source of income.
While a traditional annuity will provide a guaranteed level of income at the core of an income portfolio, flexible and supplementary income and capital growth may well be available via other investments such as property, equities, fixed interest or structured products.
These extra sources could be of particular relevance to a married couple where, if the annuitant dies, the remaining spouse will see the annuity income fall and will need to supplement that with other investments.
Not everyone will have the financial resources to build up a broad range of non-annuity retirement income but for those that do the choice is to plan early or take greater risks with the capital they do have at a later date.
'If you are looking at alternatives to annuities you have to plan ahead early enough to ensure you do have a large lump sum to give you that flexibility,' says Chris Brum, tax and financial planning manager at Clerical Medical. 'If you haven't got that much money to play with you are in a catch 22 situation as annuity rates aren't that fantastic but they do provide you with an income for life and certainty. If you go for an alternative investment you may get a slightly higher return on some investments but you can't guarantee monthly income that will continue throughout your life.'
Carl Melvin, managing director of intermediary firm Millbrae Financial Services suggests clients take a three tier approach to planning for retirement. The first is for retirees to ensure they are debt free, they should then have saved for a decent level of income to pay the bills in retirement and then have in place an efficient investment portfolio of capital to provide for future income.
'People underestimate how long they will live in retirement and make very cautious investments,' says Melvin. 'They really may well live another 20, 30 or 40 years. The investment pot needs to provide income now and in the future. You are trying to strike a balance between protecting the capital and making the capital work to provide greater financial security later.' Obviously prior to retirement individuals need to have been saving in a pension and other investment vehicles to produce this overall pot. On retirement this pot needs careful adjustment to work properly and securely. It is important for individuals to consider what they need in retirement and when.
'People's need for this supplementary income occurs at different times,' says Stuart Bayliss, director of intermediary firm Annuity Direct, 'They need higher income early in retirement but they have lots of sources for that income, they may be doing a part time job for example. Then from age 73 or 74 onwards to mid late 80s there is a lower need for income, which slowly increases as effectively long term care needs step in.
'People want extra income at different times. What might be good in the 60s might not be the best route in their 70s.'
An obvious place to start is to look at any form of tax efficient saving and investment to supplement the annuity payment, such as Peps and Isas. On retirement, if income is needed straight away, this could be taken tax free from income-producing funds within the Isa or Pep wrapper.
An alternative source of income in retirement is property. This may be a property the individual has bought outright as a capital investment and source of income if it is rented out.
'It depends on your risk profile but a lot of people are buying second properties now, people who do have a lot of pension funding,' says Brum. 'Dividends on equities are looking better but 3%-4% is not enough to live on without drawing on the capital. If you are in your 50s you have a long time period to invest over and you want something that will provide capital growth as well.'
For those who need income but do not have the capital to invest in a second home, equity release is an option.
Unless there is a desperate need for income, equity release and home income plans should ideally be saved until clients are in their 70s or 80s in the eyes of most intermediaries. The equity in their home hopefully will continue to grow as property values rise and the older they are the better deal they will get from the home income provider who will have a better idea of when they are likely to get a return on their investment.
Outside of tax efficient savings and property the first thing to ensure before even considering income is that the investments are diversified, advises Bayliss. Bonds and bond funds are a means of providing relatively secure income but these are not immune from movements in financial markets. 'Historically people have done well out of corporate bonds but there is an issue as to where the market is going,' says Bayliss. 'People who were put in these funds in the last 18 months or so probably need to stay but whether you put people in now is uncertain. We would be a little bit wary for the minute but we hope to get back to them because they are such a valuable place for income. The yield available from the FTSE through a tracker is currently attractive at just over 4%, not that different from the yield from the top 10 building societies.'
He argues that investing in equities for income early enough can help to give a client a well-diversified income portfolio. Indeed some equity income may have to be considered if clients needs do not match their assets.
'If someone has £100,000 in investments and wants to produce an income of £2,000pa they could stick it all in the bank,' say Melvin, 'But if they want £15,000pa clearly that won't work. The more income they require the more performance they need so you would have to look more to equities. Many people will tend to have an equity exposure via unit trusts or managed funds, which have an element of all the different asset classes.'
Single premium investment bonds are another option because of the ability to drawdown 5%pa and defer paying income tax on it until the bond matures, at which point the investor might well be in a lower income tax paying bracket. 'You won't necessarily guarantee the capital but as long as you are sensible in the level of income you are taking it can be paid at a set level at set times throughout the year,' says Brum. 'With all these investments you know what your expenditure is so you can juggle that with your income. It is important to go round and review your investments on an annual basis just to see how these things are performing and make sure you can continue drawing at the level you are.'
If income is absolutely vital it can usually be achieved at a cost to capital, or at a cost to the potential capital upside of an investment. Structured products are a good example of an area of the investment market where in return for guarantees, future capital upside is often sacrificed.
As ever a key consideration is the risk and reward balance appropriate to the client.
'You need to reduce the level of risk,' says Melvin. 'You've created the wealth through your working life, and in retirement it's about protecting the capital so that it lasts long enough to give you the comfort that you need. Sometimes there is no point in making more capital because it only goes to the tax man when you die.'
Plenty of other income sources in retirement than annuity alone.
Important to pay off debt before retirement
Many people underestimate how long they will live for in retirement.
The need for income fluctuates during the retirement period.
Important to use Isas and Peps as tax efficient way of supplementing income in retirement.
Property offers a form of capital growth and income.
Equity release one option for those who are in need of income.
Need to establish a well-diversified portfolio of bonds and equities to supply income.
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