October pensions supplement: The three-stage pension

The popularity of George Osborne’s unexpectedly radical changes to pension rules announced in March’s Budget was proof (if more were needed) of just how unpopular annuities have become as a way for savers to secure an income in retirement. But for people who need to think about how to manage their pension arrangements under this new regime, what are the reforms likely to mean in practice?

From next April, the world will change in at least two important ways. First, for most people in defined contribution schemes (where what you receive depends on how your investments perform, rather than how much you earn when you leave) there will no longer be a rigid cut-off at retirement where you stop saving and use your personal fund to buy an income for the rest of your life. Second, you will no longer be punished with a 55 per cent tax rate for drawing cash out of your pension but will instead pay the relevant rate of income tax on anything above your 25 per cent tax-free lump sum limit.

These reforms add up to a great deal of new options for the rising generation of pensioners: for the first time people will approach retirement as consumers who have genuine choices about whether to buy any of the products the market offers them, rather than being effectively corralled through the gate marked “Annuity.” This will enable more independently minded investors to shift their arrangements as their needs and the available opportunities change, rather than making an irrevocable decision to buy an annuity or, for the wealthy few, leaving their fund invested and taking an income under the existing and pretty restrictive “drawdown” rules.

This is not to suggest that annuities are going to disappear entirely. Most pensions experts suggest that improved and more consumer-friendly versions of this product will still be important for many people, but that they will be purchased much later in life. The problem with buying an annuity in your sixties is that, thanks to your life expectancy, it will probably have to last for 20 years and so won’t offer a very attractive income per year. But annuities bought at about 80 look a much better deal, simply because the income will not have to last you so long.

It looks likely therefore that the typical age at which people turn their savings into an annuity will shift to their late seventies, by which time most will no longer want to be bothered with the fuss of managing their investments to generate an income and will welcome the certainty that an improved and more consumer-friendly annuity can offer.

The real focus for investors in the new world of pensions is therefore likely to be how to navigate the years between the time they stop contributing and the point, perhaps 15 years later, when they will probably want to buy some kind of guaranteed income to see them out

What will they do? For those with enough pension savings, the likely answer is “very little or nothing.” Given that they are under no obligation to crystallise their pension fund and use it to buy an annuity, the most obvious choice will be to leave their money invested in some combination of bonds and equities. This will enable it to continue growing while they start taking an income from it to supplement their state pension, earnings and so on. Achieving this could be as simple as switching (usually free of charge) from accumulation units in the funds they own to distribution units, which means that the income the fund generates is paid out rather than being reinvested to buy more units. People with self-invested personal pensions will be able to manage this for themselves but it seems likely that providers of occupational defined contribution schemes will eventually enable members to leave their money invested and accessible, but to draw an income from it after they retire. Pensioners may also decide to take a percentage of their capital out each year to supplement their income but this raises the inevitable risk of running down the overall size of the pot too far.

Expect to see the fund management industry offering a range of ways to invest your accumulated savings in a mix of assets including bonds and shares in order to produce an income, while promising a degree of capital protection.

In all these cases, the key for investors will be to avoid buying products they don’t understand, to focus firmly on costs and in particular to understand that if they are offered “guarantees” with the product, these are likely to come with a large price tag that may not be immediately obvious. Watching costs is especially important for those who want to leave their fund invested and start taking a regular income from it because, once you stop reinvesting everything back into the fund, high charges will quickly erode what you have left.

The upshot of all this is that investors in future probably need to plan for a three-stage pension lifecycle—saving, drawing an income and then buying an annuity—rather than today’s typical two-stage process.