New pension freedoms are no reason to gambleby Ruth Jackson / March 23, 2016 / Leave a comment
Last April, pensions underwent a revolution. The arrival of new freedoms meant that pensioners were no longer forced to buy an annuity with their pension pot.
Last April, pensions underwent a revolution. The arrival of new freedoms meant that pensioners were no longer forced to buy an annuity with their pension pot. The changes were greeted with joy by most people approaching retirement as annuities had become incredibly unpopular over the past decade, thanks to declining returns. Back in 2009 a 65-year-old man with a £200,000 pension pot could expect to buy an annuity with an annual income of £14,300. By 2016 that same man’s annuity income had fallen to £11,248.
The other drawback with annuities is that once you’ve bought one your pension pot is gone. Even if you drop dead a year later, your family can’t get any of those hard-earned savings back.
It’s no surprise then that in the first three months after the pension freedoms came in, sales of annuities fell by 86 per cent compared to the same period two years earlier.
Instead people are opting for “income drawdown” or withdrawing their pension funds to invest in income bearing assets elsewhere. Figures from the Association of British Insurers show that £2.2bn was paid out via 606,000 income drawdown payments in the first six months after pension freedoms were introduced.
Income drawdown allows you to keep your pension pot invested in the stock market while taking a regular income from it. The benefits are that you can often enjoy a better income than you would with an annuity, and you could have some pension left to pass on to your children or spouse when you die.
For example, a 65-year-old man with a £200,000 pension pot could draw an income of £1,000 a month for 21 years and still have £63,430 left in his pension pot (assuming annual investment growth of 4 per cent), according to calculations by Hargreaves Lansdown.
The drawback to income drawdown is that your pension pot remains invested in the stock market. That can be a volatile place, as the past few months have shown. If your investments don’t grow as you’d hoped you run the risk of running out of cash. In the above example, if that pension pot grew by only 2 per cent, rather than 4 per cent, the man would run out of cash at the age of 83.
“An increasing number of people are using drawdown, as they like the idea of having more control over their pension savings, but it is all a balancing act that can be hard to get right,” says Mark Stopard, head of product development at Partnership.
You don’t have to stay invested in shares in order to draw an income from your pension pot. You could choose to invest in retail bonds instead. They are issued by companies looking for funding; you invest and get regular interest plus the return of your capital at the end of the term.
With interest rates of 6 per cent available, retail bonds can be very tempting for pensioners looking to get an income from their investments. Retail bonds aren’t completely risk-free though, there is a chance the company could go bust, taking your money with it.
Another income option some pensioners consider is investing in buy-to-let property. But there are a number of reasons why that is a high-risk, expensive way to fund your retirement. First, if you need your pension pot to fund the property purchase you’ll be taxed heavily. That’s because you can only withdraw 25 per cent of your pension savings tax-free; withdraw the lot and you could end up having to hand up to 40 per cent over to the taxman.
Second, buy-to-let doesn’t guarantee a regular income. You are reliant on the properties being occupied, and by people who pay their rent. Finally, the tax regime on buy-to-let is changing, making it even less appealing.
As you can see there are a number of ways you can turn your pension pot into a regular income when you retire. But just because you don’t have to take an annuity anymore doesn’t mean you shouldn’t get one.
“It is far too early to talk of the death of the annuity,” say Danny Cox, a chartered financial planner at Hargreaves Lansdown. “People want and need a guaranteed element to their income, to cover their basic spending needs throughout their retirement.”
The answer then is to build a mix of pension incomes using part of your pension pot to buy an annuity giving you a guaranteed income to cover your basic living costs.
“We believe that, for many people, buying an annuity is the best way for them to access some of their pension,” says Patrick Connolly, a certified financial planner from Chase de Vere. “Everybody should have secure income to cover their basic living costs in retirement. People shouldn’t be gambling with the income they might need to pay their day-to-day bills and living expenses.”