These days anyone coming up to retirement with a money purchase pension fund is faced with a bewilde...
These days anyone coming up to retirement with a money purchase pension fund is faced with a bewildering array of choices.
There are conventional annuities of many kinds - with and without spouse's pensions, with and without escalation, in advance and in arrears, and so on. Then there are investment-linked annuities which have become increasingly popular as the cost of conventional annuities has increased, and which now have many options of their own. Finally, there is the possibility of phasing retirement or using an income drawdown arrangement, possibly using a self-invested option.
Consequently it is hardly surprising that many people find retirement confusing and that the expertise of independent financial advisers (IFAs) in this area is increasingly being recognised.
In many cases there are two fundamental considerations. The first is whether the client's funds in retirement are to be actively invested or not. Conventional annuities provide high levels of guarantee but they will never provide more than the guaranteed level.
Phased, drawdown and investment-linked annuities all have the potential for future growth but with an increased level of risk. Your client must understand the basic trade-off between potential investment return and the risk involved.
The other fundamental issue is perhaps less well understood by clients. This is that the value you get from any of the options depends largely on how long you live for. If you buy an annuity and then die quickly, the return will probably be less than you paid in. On the other hand, if you live to 100 you will get tremendous value from the annuity because those who die quickly effectively subsidise your pension.
With phased and drawdown this cross-subsidy does not exist. If you die soon after you retire, your dependants can receive the full fund (less the 35% tax charge for drawdown), but if you live longer the mortality drag effect kicks in and you may well end up with less overall than if you had bought an annuity immediately. Communicating that to clients is by no means a straightforward task.
But there is yet another level of complexity. This is perhaps best illustrated with a conventional annuity, although it is relevant to other options as well.
Level or escalation
Normally a pension can be level, or it can escalate at a fixed rate or in line with prices (RPI). The more escalation you build in, the lower your starting pension. But in time the escalating pension will probably overtake the level one, first in the amount received each month, then in the total payments received, and finally in inflation-adjusted value.
Some people thought it might be more prudent to go for the escalation because level annuity payments will be eroded by inflation. This view led to the introduction of limited price indexation (LPI - the lower of RPI and 5% increases each year) for occupational schemes and contracted-out benefits in the Pensions Act 1995. But is it right?
The counter-argument is that you should take as much income as possible up-front (through a level annuity) and invest a portion to offset the effects of inflation on your income. If a level annuity paid you £600 a month and an index-linked annuity £400, then you would choose the level annuity and save £200 a month from it initially to offset the effects of inflation later. If you die, this money passes down to the next generation, and if you live a long time it offsets the effects of inflation in later years.
There are obviously a lot of variables in this equation, but we can do some calculations to assess the effectiveness of the strategy.
Take the example of a 60-year-old male looking for a single life pension. The figures of £600 a month for a level pension and £400 a month initially for an RPI-linked pension are fairly close to what he could currently buy with a £100,000 personal pension fund.
To illustrate a range of possible scenarios, let's look at average inflation rates of 2%, 5% and 8% a year over his retirement period. Although 8% looks high in current economic conditions, in the longer term significant changes in inflation rates are certainly possible, as Table 1 demonstrates.
Then assume investment returns (net of expenses) of 1%, 3% and 5% a year above inflation. These returns are relevant because in the early years we are investing the difference between the payments from the level annuity and the RPI-linked one.
Table 2 shows the ages when the total value received from the RPI-linked annuity passes the total value from the level annuity plus the investment returns. Put another way, it shows the age when the fund we have built up from the excess level annuity payments runs out.
Based on recent government estimates, a man who is currently aged 60 might live, on average, for another 20 years. If he does die at around age 80, taking the level annuity and reinvesting is likely to be better for him if inflation averages below about 4%-5%.
Another way of looking at this is to consider what value he will get from the two annuities if he dies at a certain age. Table 3 illustrates this if he dies at 70 and if he dies at 90. In this case, I have assumed a 3% 'real' return from the money received from the level annuity and reinvested.
If there is still money left in that 'pot' when the man dies, I have assumed it will be paid out as cash on death. Otherwise I am discounting the actual cash payments the individual takes from both. Bear in mind that the initial purchase price in both cases is £100,000.
This again illustrates how significant the effect of inflation is on this comparison. If inflation remains very low it is clear that a level annuity is going to be a much better buy than an RPI-linked one. But if inflation takes off again, the value of a level annuity could be severely eroded and this could cause real hardship for the individual.
So there are two spec
Pension savers need to engage with their retirement options far earlier than is currently normal to ensure they save enough through their lifetime, according to a report from the Association of British Insurers (ABI).
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