If your pension savings are to be converted into a flexible income when you retire, you must think carefully about making the right investment decisions.
This month marks the second anniversary of ‘pension freedoms’ – the liberalisation of the UK pension regime that gives people over the age of 55 the freedom to use their savings in a variety of ways.
Savers have cashed in over £9 billion from their pension pots since the reforms were introduced1. The Treasury says that this data shows that the reforms have “proved to be very popular”, and that “giving people freedom over what they do with their hard-earned savings is the right thing to do”.
While experts will argue over whether the legislation will have a positive or negative impact on the long-term retirement landscape, it has certainly breathed new life into pensions and helped to improve their appeal to a working population that is not saving enough for retirement.
However, the new rules – or more specifically the removal of the old ones – have left many retirees exposed to a variety of risks, and placed an enormous responsibility on the shoulders of those who choose to draw a flexible income from their invested pot.
In the past, legislation was in place to help maintain a certain level of income through retirement. For instance, prior to 2015 there was a cap on the amount that most people could withdraw from a drawdown plan. The maximum withdrawal was broadly in line with the amount an annuity would pay, so an annuity – offering a guaranteed lifetime income – was often the preferred option.
However, since 2015 retirees have been free to draw an unlimited income from their invested pension fund – and avoid annuities altogether. Indeed, there has been a significant switch from annuities to ‘flexi-access drawdown’ since the reforms were introduced – a pattern that is likely to continue.
Drawdown is much more flexible than an annuity. However, drawdown requires individuals to generate a potentially rising level of income using assets whose returns can be unpredictable.
That problem is exacerbated because nobody knows how long they will live. Uncertainty around life-expectancy forces retirees to think long and hard about taking withdrawals at a rate that also ensures their fund doesn’t run out.
Given the requirement for a predictable income over an uncertain timespan, it may be tempting to invest in a low-risk portfolio – but this may well damage the prospects for decent returns. Research from Barclays shows that over all 10 and 18 year periods from 1899 to 2016, the probability of UK equity outperforming cash was over 90%.2
Furthermore, research indicates that, for higher withdrawal rates, a substantial exposure to equities tends to produce higher probabilities of success, albeit with higher volatility.3
“How much equity you hold in your drawdown portfolio will depend on your age, health, lifestyle, risk profile, and so on. What I can’t do is recommend that people hold a certain percentage – as everyone’s situation is different,” says Ian Price, divisional director at St. James’s Place.
“Without doubt, anyone who is approaching retirement should talk to their financial adviser. They will be able to recommend an appropriate drawdown portfolio that will provide the sort of income you are targeting.”
“That portfolio is likely to include an appropriate selection of income-producing assets, such as global equities, bonds and commercial property, which offers diversification to avoid over-exposure to any one asset class or geographic region,” says Price. He cites market events since the Brexit vote as a recent example. Global assets have not only mitigated UK-specific risks, but have also benefited from sterling’s weakness.
“Your adviser should also talk to you about holding funds in cash, so that you are not forced to take withdrawals from more volatile assets. It’s effectively reverse pound cost averaging because, if the value of an asset falls, more units or shares have to be encashed to provide the same income. Those who take an income from shrinking investments early on in their retirement can do irreparable damage to their portfolio.”
“Your adviser will also be able to help you determine an income strategy that is sustainable over the long-term, and has the flexibility to adapt if your fund has suffered from poor market conditions,” says Price.
“You may also consider buying an annuity with part of your pension fund, to cover essential spending. In fact, annuities may still prove the best option for some."
`Income drawdown' will reduce the size of your pension fund and the investment growth may not be sufficient to maintain the level of income you wish to draw. If you withdraw money at a rate greater than the growth achieved by your investments, your remaining fund will reduce in value. The level of income you take will need to be reviewed if the fund becomes too small. This is more likely the higher the level of income you take.
The income you receive may be lower than the amount you could receive from an annuity, depending on the performance of your investments.
The rules governing how much income you can take directly from your pension fund may change. This could mean that the income you can take from the investment no longer meets your requirements.
1 www.gov.uk 25 January 2017
2 Barclays Equity Gilt Study, 2 March 2017
3 Return Sequence and Volatility: Their impact on sustainable withdrawal rates. Matthew B Kenigsberg, Prasenjit Dey Mazumdar, Steven Feinschreiber. The Journal of Retirement, 2014.