Will 2015 be the Year of the Lamborghini? You could be forgiven for thinking so, following the changes to pension rules announced in the Budget. These were clearly intended to signal a big shift towards individual control over how we use our pension savings and away from the effective obligation to buy an annuity sometime after reaching 55. With that necessity removed, several hundred thousand people per year will be free to manage their retirement income as they see fit, which includes investing in premium Italian automotive engineering.
I feel torn about this. On the one hand, I’m all in favour of people having greater scope to take control and do things for themselves.
DIY investing is gaining popularity, and other Budget moves to encourage it, such as the new £15,000 annual ISA allowance, will add to this. Equally, I’ve been put off pension saving ever since I left full-time employment: the loss of employer contributions removed a big slice of the incentive to tie up money in this way. These changes have gone some way to making me think differently.
On the other hand, liberalisation of the pension rules has greatly increased the challenges facing DIY investors and made the range of knowledge and skills they will need to succeed much greater.
The life cycle of pension saving falls into two parts: the accumulation (saving) and decumulation (spending) phases. Up until now, DIY investing has been concerned almost exclusively with the first—how to save and invest money to build up capital during the decades of one’s working life. This is hard enough to accomplish in practice, but is at least relatively easy to understand in theory.
But the spending phase presents many challenges, particularly if you decide to exercise your new freedoms from April 2015 and ignore the hitherto default option of taking out an annuity, otherwise known as an insurance policy, which guarantees you an income for life based on how much you have saved. This approach has recently produced much less attractive levels of income for new annuitants but retains the benefit of being a simple (if inflexible) solution to a big problem—outliving your savings.
If more people are now to move away from annuities as a way to fund their retirement, they are very likely to end up having to decide on the merits of more complex products with more moving parts. And if they plan to try to manage the gradual spending of their savings over the years of retirement for themselves, they will face even more challenging investment problems than when they were accumulating their fund.
In the absence of an insurance policy, the only other way to fund your retirement is to leave your capital invested and live off a combination of the income it produces and a portion of the capital itself, the idea being that over the years your remaining fund grows to some extent, helping to offset the erosion as you progressively spend it. The catch, of course, is that you can have no idea how long you are going to live.
(As an aside to those who think buy-to-let property is the answer, the inconvenient truth is that rental properties require ongoing investment if they are to remain capable of generating worthwhile income, so you will need significant capital aside from the property itself in order to maintain it.)
Drawdown, as it is called, is an extremely complex process to get right. Experienced investors know that forecasting even over short periods is all but impossible and that the only thing that enables them to recover from setbacks is the passage of time. Both these difficulties become more acute during drawdown—it’s impossible to forecast how long their money will have to last and they have less and less time to recover from any mishaps. Investment challenges don’t get much tougher than that.