DIY investor—the alternative to an annuity

Most people find financial matters both scary and dull—a particularly toxic combination—and would rather leave their affairs in the hands of a specialist. I have every sympathy with this attitude even though, rightly or wrongly, I have chosen a different course. But what I find striking about the situation now unfolding is that the new pension freedoms will probably result in the biggest one-off increase in the number of DIY investors this country has ever seen.

Most people now grasping these freedoms will not take formal financial advice because they don’t want to pay the costs involved. Many will not seek guidance from the government’s Pension Wise service. Even if they do, they are ultimately going to be the ones taking responsibility for their money and working out how quickly or slowly they can afford to spend it. Whether they are aware of it or not, that puts them firmly in the DIY camp, the average age of which has probably edged up a few years recently.

So far, the story has mainly been about DIY dis-investing—recent figures showed that about 60,000 of the 400,000 people eligible to withdraw pension savings under the new rules had done so, pulling out £1bn between them in the first two months. That averages out at a bit less than £17,000 each, suggesting that most were cashing in very small pension pots and using the money for fairly immediate purposes.

A windfall of that size is handy, but in the great scheme of pension freedom it’s beside the point. The real question is what this new breed of DIY investor will do with the much larger sums that are now under their control and that must sustain them through the decades ahead. If you don’t turn your savings into a lifetime income via an annuity—and the evidence is that few now will—you will have to put it somewhere else. For most, that will mean some sort of drawdown account that will leave it invested in the financial markets while you take out what you need to live on. This means that a growing number of people will have to remain exposed to the vagaries of the markets in order to give themselves a chance of achieving capital growth, to help offset the withdrawals they will need to make from their fund.

Taking investment risk is not a bad thing. Quite the opposite, provided you spend some time thinking about how much you are taking and how to mitigate it. So how should people who choose to leave their pension savings invested in the markets deal with the risks they will face? First, they will have to look hard at the fees they are paying because, particularly once you stop contributing and start taking income, high fees will have a very marked impact on the value of your fund. It’s likely the government will cap drawdown fees so that problem might be taken care of centrally. Second, they will need to ensure their holdings are not too concentrated: broad diversification will be important for people who cannot easily withstand big drops in their fund’s value.

Third, they will need other sources of income, which for many will mean wages. A century ago, 70 per cent of men aged 65 were still working; today the figure is about 10 per cent. But the trend is clearly going into reverse. The employment rate among the over-60s is rising rapidly and surveys suggest that about a quarter of those approaching retirement expect to work part-time once they quit the day job.

The hope must be that a more gradual withdrawal from the world of work will not only help this newly-minted band of DIY investors to remain active and engaged but will also offset the market risks they will need to take in this new age of pension freedom.