This guest blog is by Matthew Baines, a Senior Consultant at Beckett Financial Services with whom SME Strategies is pleased to work. Matthew is an experienced Chartered Financial Planner. In the article Matthew explains the differences between the annuity option and the drawdown option in retirement with some of the pros and cons of each. He also gives some useful guidance on how much we might need to retire in comfort!
Publishing this straight after Christmas seems an opportune time for us to review our pension(s) as we go into the New Year.
How to manage your retirement successfully
So, you have done the hard work by being sensible and saving into a pension for most of your working life. Whether this be through a workplace pension or personal arrangement, you have built up a sum of money which is to now be used to fund your retirement. Unless you are fortunate enough to have been enrolled in a final salary or career average earnings scheme, you will likely be in a position where you have to make some careful decisions on how to manage your money in retirement. The decisions you make and the way you manage your money may have a significant impact on what type of retirement you can enjoy.
Decision time – is it the annuity option?
Before pension freedoms were implemented in 2015, the primary option for the majority of people building funds in a defined contribution pension scheme was to buy an annuity. This is essentially an exchange of capital for a guaranteed income for life. Unfortunately with annuity rates tumbling in recent years the amount of money required for a comfortable retirement income has increased significantly. The current rate for a 65 year old buying an annuity tends to range from 3.2% to 5.5%, depending on the features selected. As an example, you can currently receive £5,410 for every £100,000 held if selecting a single life, level (ie it falls in real terms because inflation eats in to it) income annuity with a 5 year guarantee. Additional benefits such as escalating income or a spouse’s pension will reduce the amount you can receive. Based on data from the Office of National Statistics, a single person earning £50,000 may require £26,157 in retirement. If we assume full entitlement to the state pension of £8,546 from age 66/67, this leaves an income shortfall of £17,611 which would require a pension pot of £325,527 to fund just a level income annuity, a significant amount by most peoples’ standards. To include a 3% per annum increase in the annual pension, the shortfall of £17,611 would cost around a whopping £ 483,951 to fund. With the option to take 25% of the pot as a tax free lump sum (a sum many use to cover planned capital expenditure) an even larger pot than this may realistically be required.
Decision time – or is it the drawdown option?
Pension freedoms gave people the freedom to take their pension how they saw fit. This means that, if you want to, you can draw out your entire pension in one go but not usually before the age of 55. In most instances this is ill-advised as whilst the first 25% will be tax free, the remaining pot will be taxed as income in that tax year at your marginal rate. For most
people, they will want to make their money last for the rest of their lives. With life expectancy increasing, many people may be looking forward to a 30+ year retirement. Making your money last for this period of time, without any guarantees, requires careful management, but can provide greater flexibility in retirement, something many people value. It also offers the opportunity for you perhaps to withdraw more in the earlier years of retirement when you are more active and reduce your drawdown later in retirement as life ‘slows’ down.
As you approach retirement, if you are going to take an annuity, you are likely to want to decrease your risk exposure in the final 5 years before buying it. This is to help reduce the impact of any market falls before you utilize your capital to buy your lifetime income. For those wishing to move into drawdown, there is still the argument for reducing your risk exposure, but the pension in this instance is now being viewed as a 35 year investment, not a 5 year one and so the requirement to reduce risk is lessened. The reduction in risk exposure should be part of an overall reduction in risk as you move from accumulating funds to spending them (although there is no specific point in time where the capital is going to be used unlike in the purchase of an annuity at the beginning of retirement). This change in investment strategy is an important part in the transition to drawdown. An example of risk reduction might perhaps be to increase exposure to bonds and reduce equity exposure.
How to make my money last?
One thing I can promise is that no one knows how investments are going to perform from year to year. You will have heard many a time that history is not a guide to future performance. Even the brightest minds in economics and fund management don’t have a crystal ball. Therefore, it is not a case of investing in whatever did best last year, or gambling on the ‘hottest’ new investment tip (Bitcoin anyone?). It is about building a sensible portfolio which will attempt to deliver the returns you require over a sustained period of time whilst taking a level of risk you are comfortable with and have the capacity to take. Cash flow analysis is a vitally important part of retirement planning and will help your financial adviser illustrate to you how your pension and other assets will be used to fund the retirement you want. It can be used as a tool to identify whether there are areas you need to cut back on or not and whether the 3 year old car really needs replacing or not.
So how much can I take in drawdown?
This is of course a difficult question to answer! It will depend on your timeframe (how old you are when you start drawing on the funds), how much capital expenditure you have planned and whether you want to leave any funds to your family. There is a crude rule of thumb that says 4% is a sustainable withdrawal rate. However, further more in depth research into the UK investment market suggests this should probably be closer to 3.5%. If you are in a fortunate position where you have built other funds in say ISAs which can be used for capital expenditure and you can keep withdrawal rates from your pension to around 3.5% whilst ensuring your investment strategy is appropriate, you are likely to be in a healthy position. This cautious approach should mean that your annual withdrawal can be increased each year in line with inflation. It will also be able to provide the same income to your wife/husband or civil partner if you pass away before them and your pot, if managed correctly, should not run out in your lifetimes. It is of course going to very much depend on your individual situation and pension so please remember this is very rough guidance and should not be taken as advice.
With attractive death benefits, the wish for people to pass on a legacy to their loved ones and the desire for greater flexibility in retirement, it is unsurprising that annuities now only make up around 29% of the market. There is of course still a place for them; some people want to know their income is guaranteed and is not subject to investment performance. For some people investment risk of any type is not appropriate. However, with drawdown plans now making up 71% of the market and life expectancy at an all time high, the careful management of the approach to retirement and the management in retirement is more important than ever. Many people may wish to seek specialist professional advice to guide them through the complexity of issues to find the most appropriate choices for their particular circumstances and attitude to risk.
At Beckett Financial Services we meet the cost of the first meeting with one of our Private Client consultants. This enables a prospective client to understand how we might be able to help them and gain trust in their adviser. Please contact me if you would like to arrange an initial meeting. We also work closely with accountants and tax advisers of business owners to maximise legitimate opportunities for efficient financial planning.
Chartered Financial Planner
Beckett Financial Services