Income in retirement - let's keep it sensible
As all retirees will have full access to their pension entitlements without any fear of penalty from next month, it is predicted the annuities market will shrink to a shadow of its former self - even though it will still be possible to buy an annuity. The UK's newly introduced pension freedoms are however no different to those already available across the pond and indeed have been for years. There are many fears, perhaps justified, that consumers will generally be unable to make the most appropriate choices in retirement, however, evidence from America would suggest the contrary. One thing is certain though, we are soon to find out.
A retiree's primary intention is to provide a secure and perhaps a level or increasing level of income during and throughout their retirement. This is an increasingly difficult task given the low interest rate environment we are experiencing combined with equally low gilt yields and GAD rates and the figures used to calculate incomes from annuities and income drawdown plans. Therefore they need to ensure their capital lasts longer and retains its power to provide long-term income if and when required, so it follows developing a comprehensive investment strategy that is equally as important as the withdrawal/income strategy. So where to invest and how much to withdraw?
Where to invest?
Table 1 highlights three very simple options for a male aged 65 looking to provide an income throughout retirement with a pension pot after tax free cash has been taken of £45,000. Statistics from the Office of National Statistics (ONS) suggest this period to be on average 18 years.
For Option 2 we have assumed a withdrawal of 5.5% to match that offered by the annuity, however there is much academic research from both sides of the Atlantic suggesting that to maintain an income throughout retirement, this percentage should be much lower to allow the fund value to retain its purchasing power in future years. Figures of between 3% - 4% are suggested1. Taking excess withdrawals from the pension pot will simply erode capital and even allowing for mortality gain as the client gets older, the income available will ultimately reduce over time.
Mortality gain simply means the increased factor premium applied to a pension pot in calculating the annuity income as a client gets older given that their life expectancy is reduced, resulting in a higher income in retirement. Table 2 shows the income a client would receive from an annuity if they retired at ages 65, 70 and 75. The increased income reflects the mortality gain.
Locking into an annuity, however, may not be the most efficient way to draw income in retirement, hence the (growing) popularity of flexible drawdown. As previously mentioned, enhanced withdrawals from a flexible drawdown strategy require very careful consideration and a very well designed, equity based investment strategy.
Option 3 may offer an alternative means of providing a stable income in retirement whilst maintaining the value of the pension pot for future years without the need for any complex or risky investment strategy. This could mean that a client enjoys similar levels of income to those offered by the annuity without actually buying an annuity during times of low interest rates. The full value of the pension pot would remain intact, provided in this case, that the FTSE 100 did not halve in value over the 6 year period in which case the amount invested would be reduce by 1% for every 1% fall in the index.
Although not a guide to the future, statistics from Investec show that since 1984 when the FTSE 100 was established, taking every rolling 6 year period between then and April 2014, on only 56 occasions (0.9%) would a client have received back less than they invested. In over 99% of occasions, clients would have received back their initial investment in full. This means that should the client decide to buy an annuity in the future they would not only benefit from any mortality gain premium given that they are now 6 years older, they would also have maintained the purchasing power of their pension pot meaning potentially higher levels of annuity income.
There are of course many different income in retirement strategies, but what is clear is that given these forthcoming freedoms, clients need to be informed and educated on the wider options available, allowing them to make sensible decisions in sustaining their standards of living throughout retirement, a situation everyone stands to benefit from both now and in the future.
1 Source: Figures based on FinalytiQ's white paper 'Pound Cost Ravaging: Understanding Volatility Drag, Sequencing Risk & Safe Withdrawal Rates in Retirement Portfolios'.