Planning retirement income is no longer just a case of choosing a product. Athole Smith discusses the importance of taking a holistic view
Is retirement income just a modern name for the traditional pension or is it something more significant?
In what some would refer to as the good old days, people simply had a pension. That’s what they saved into and that’s what they lived on when they retired. Generally the contributions came from their employer and they didn’t need to give it a second thought. Importantly, when it came to retiring there was a pot of money to live on that paid out monthly. Any mention of retirement income was likely to be met with a blank stare. Life, it might be said, was simpler then. And as for advice, why would anyone need it?
Today the landscape is so very different. Defined benefit (DB) pensions are going the way of the northern white rhino (12 left and counting). People are living much longer and need an income over a period that can, in some cases, extend upwards of 30 years and beyond. The issue of how people support themselves during this stage of life has never before been more acute. The need for advice, information and general support has never been greater.
With the Association of Consulting Actuaries expecting that by next year, 60% of all active members of pension schemes will be in defined contribution (DC) arrangements we are seeing the transfer of risk moving increasingly from the employer to the employee. Likewise the risk transfer from the state to employees has accelerated over recent years with state pension, DB schemes and healthcare arrangements too, falling foul of such changes.
At a very basic level, the state pension will, for the majority of people, provide an income of sorts in retirement. But the total annual amount is currently less than £5,000 which is unlikely to support even the most frugal of people, coping on the strictest of budgets. Research which we conducted, rather startlingly, revealed that two out of five of people who planned to retire in 2009 believe the state pension and other savings will be sufficient to support them in their retirement.
A blended approach
Current mass market retirement wealth tends to sit in low risk assets such as property, annuities, state pensions and defined benefits. Wealthier individuals have similar assets plus some much riskier assets such as shares, ISAs and cash. Future generations will no longer have income security from defined benefit schemes and state benefits, and will also face huge uncertainty about the volatility of their other assets such as properties and shares.
Despite all the negative comment and publicity, a pension saving product remains one of the most powerful means of building up a pot of money that can be used to provide an income in retirement. With its tax relief and the potential for employer contributions in occupational schemes, its attractiveness is unrivalled. Even still, many of tomorrow’s pensioners are turning their backs on contributory pensions to boost their income today and this is ill-advised. The decision by some to stop paying into a pension could mean a rise in pensioner poverty in years to come. To demonstrate this, Prudential’s research reveals that the number of people who expect to rely on state pensions and their own savings is set to rise to 27% over the next 10 years compared with 22% of those retiring this year.
If there is one thing that is very clear, it is the real need to save today. The cost of delay is phenomenal. A 40-year-old saving into a pension for the first time will need to put aside a third of their earnings until they reach age 65 if they wish to retire on a pension equivalent of two-thirds salary. A 30-year-old would only need to save in the region of 20% of salary to get the same pension.
With statistics like these it is little wonder that contemplating retirement income needs is such a daunting prospect. The array of products – which are all designed to serve a specific need and provide consumers with choice – can be confusing. This point, of course, supports the need for consumers to seek financial advice before they come to retire.
Any solution must do two things – remove or reduce the risk of outliving the assets and the risk of inflation destroying the purchasing power of money. Each of these risks continues to be underestimated by consumers. For a group of 65-year-old men, average life expectancy is 21 years; however, one in four will reach age 93. Clearly no individual knows how long they will live so longevity insurance is essential. Even when longevity risk is understood, inflation risk remains.
So in order to truly understand retirement income needs, a client needs, in the first instance, to understand longevity risk and the impact of inflation. It’s then that they can really get to grips with the myriad solutions in the market.
Turning now to some of the choices available in the market
Annuitisation or drawdown
The most obvious choice for people as they enter retirement is to look at annuities, but when annuity rates are low it may be perceived as offering poor value. The alternative is to consider income drawdown, using the wealth from an individual’s pension pot to provide an income until such time as they wish to or have to buy an annuity. While drawdown offers flexibility the individual must still shoulder the investment risk.
Asset backed alternatives
At a time when accumulated pension saving received a battering as fund values fell, asset backed annuities provide the opportunity to recover lost ground through the potential of increasing income levels during retirement.
Asset backed annuities can offer the combined advantages of mortality bonuses and ongoing exposure to assets such as equities, property and corporate bonds to provide growth in income. The with-profits annuity is designed to meet the needs of customers who do not want to lock into guaranteed annuities but who don’t want to take on too much risk through unsecured income.
The Prudential product works by offering customers a choice of income levels from which to choose. The minimum income is guaranteed for life and, under no circumstances, would a customer get less than this. Once the customer has chosen their income, they are told the investment return which will be needed to maintain the income for life. If a higher return is achieved then income will increase. If a lower return is achieved then income will reduce but never below the minimum. Other with-profits annuities available in the market operate in similar ways although specific features will vary from company to company.
And then there’s equity release. Once considered to be on the fringes of retirement planning. Today, equity release meets a vital need for many people who, at retirement, spend more money on leisure and require the ability to draw income flexibly to complement their regular pension income. This need for income falls as people become less active and then rises again in later retirement as health costs increase.
But many peoples’ income is fixed or rises only in line with inflation. The real benefit of equity release is it allows customers to supplement their retirement income to match their individual needs.
And equity release, like income drawdown, could provide a powerful alternative to taking an annuity, particularly before someone reaches the age of 75.
However an individual is thinking about how to structure their retirement, their first port of call should be a financial adviser.
And the alternatives
The list here could go on and on. Besides property, any other form of saving can be considered to be part of a client’s retirement income planning. Attitude to risk will play a big part in the type of investment vehicle chosen. For the majority of investors their core holding tends to be in relatively cautious funds with satellite holdings in riskier funds. And this typifies retirement income planning today.
In the traditional sense the pension is no longer the be all and end all of retirement income. It remains a key component but the challenge today is to find the right mix of assets with the ability to produce an income while meeting the risk and lifestyle profile of clients.
Athole Smith is head of proposition and market strategy at Prudential
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