Pensions & annuities: how to approach retirement planning with confidence
What options do we have at retirement?
Thanks to pensions freedom legislation, we have two options on retiring: purchase an annuity, or take a tax-free lump sum from the pension we’ve saved up over our life – usually up to 25% of its total value can be taken tax-free.
If you take a lump sum, for the remainder of your money you have another two options:
- Purchase an annuity, whereby you hand the money over to an insurance company which pays you an income for the rest of your life (see below).
- Drawdown, or flexi-access drawdown. After taking your lump sum, with the remaining 75% you can draw down from the pot as and when you want it. The money remains invested, sometimes with the same provider or sometimes with a new one.
Be aware of the risks of drawdown. Say for example you’re averaging an annual 5% investment return over time and you’re withdrawing 10% annually: that’s going to erode your pension fund over time so there’s a risk that you’ll run out of money.
It must be carefully managed, so this is one of the few times that I almost insist that you seek good professional advice from a Certified Financial Planner (CFP) to make sure that your fund maintains its value or reduces within an expected period of time. The last thing you want to do is get to a vulnerable age later in retirement where your funds have run out. You can find a list of CFPs here.
What is an annuity?
An annuity is basically a lump-sum investment that provides you with a guaranteed income for the rest of your life. Let’s say you’ve saved up £100,000 in your pension pot when you reach retirement age (which is age 55 or older). You’d then shop around the market for the best deals, give the annuity provider that £100,000, and for the rest of your life you receive a monthly income from the provider (normally a life insurance company).
You can shop around using the regulator’s comparison site.
The income is determined by your total fund, your health, and it can also differ geographically. Generally it’s guaranteed and you can have ‘bells and whistles’ added to it. For example, that might include a scenario where if you were to die, does any of your pot go to your partner? Every year is your income going up in line with inflation? If you were to pass away in the first five years, is a lump sum payable to your beneficiaries?
These could be attractive bells and whistles, but when you add them to your annuity, the initial level of your income reduces, so bear that in mind. Consider how long it will take you to ‘break even’.
Another thing that affects the income you’ll receive from an annuity is your health – and this is the one time when being in poor health or being a smoker actually goes in your favour. That’s because actuarilly – in terms of life expectancy – if you’re in poor health, you’re obese or you smoke, your life expectancy is reduced and therefore the annuity provider is paying your income for a lesser period of time, so they can pay a higher income.
These are called impaired life annuities and they generally pay a higher rate than standard annuities.
Are annuities still relevant?
Absolutely. Annuities are still an important part of sound financial planning and can provide you with guaranteed, stable income during your retirement years.
What are the key advantages and disadvantages of drawdown versus annuity?
The main difference is certainty. With an annuity we have guaranteed certainty that we’ll receive a fixed level of income for the rest of our lives, irrespective of stock markets, interest rates or anything else.
But with that certainty, we give up the asset – our fund. If we were to die prematurely, or if a husband and wife die prematurely, the asset is lost. If you were both to die after one payment, the rest of that £100,00 remains with the insurance company. We gain certainty but lose our asset.
With drawdown, we don’t have a guaranteed level of income, but when we die whatever is left can be passed to our beneficiaries. If we have children and a large pension fund, this is often a key driver in decision-making – people want the money to pass onto their children. If you die before the age of 75, it passes tax-free; after 75, beneficiaries will pay income tax on the money they receive.
How do you know which is right for you?
When it comes to your main source of retirement income, going to see a CFP is so important to make the right decision. Here are some of the things to take into consideration, and remember that you can annuitise later on, it doesn’t have to be the day after your retirement or involve your whole pension fund, you could annuitise part of your pension.
As a general rule you want your basic overheads (food, utilities and so on) secured via either your state pension, a guaranteed annuity, or a defined benefit pension. Any excess income that covers discretionary spending like holidays, you can make the call depending on your attitude to risk: take out an annuity or go with drawdown. Thinking of things like this gives you the security (annuity) of knowing your basic expenses are covered, and you have flexibility of payments and peace of mind that if you die prematurely then some of your money will still be passed to your children (drawdown fund).
Although it’s important to think about the family wealth and your children, first and foremost your pension is for your retirement income, not your children. The most important thing is to secure your income first. When we’re younger, we’re more care-free and adventurous. As we get older, we become more cautious and we want to work less. I’ve noticed this continues through retirement – in early years of retirement we might feel more adventurous and spend more money doing things, but as we get into our later years we become more vulnerable and probably eventually need looking after.
Having an annuity income in later years is a nice certainty for cash flow, meaning it’s something we don’t have to worry about. That’s often overlooked when considering pensions versus annuities – once the decision has been made to purchase an annuity, that’s the end of the decision. With drawdown, you have to keep an eye on things regularly – typically yearly – making sure the asset allocation between our funds is correct, making sure there’s sufficient cash to provide us with an income. As you get older, is that something you really want to do?
You can get the best of both worlds if not – use drawdown in your earlier years of retirement, and then annuitise in your latter years when you want peace of mind and to secure your income. You can annuitise some of your fund and I think that can be a really good option. It secures your income and gives you flexibility to do what you want to do.
How much I can safely draw down each year, I’ve heard of a ‘4% rule’?
The amount of income you draw down will depend on your resources from any other assets – in fact, whether you opt for drawdown or not will be dictated by your other assets.
Let’s use an example: suppose you have £100,000 in your pension pot and that’s your only retirement fund. It wouldn’t be too wise for someone to go into drawdown with that money if they have nothing else to fall back on, especially if they’re going to draw down aggressively, i.e. large sums. Because once that money’s gone, it’s gone.
We tend to draw down amounts as pounds – we say to the pension company ‘I’d like £5,000 pa from my pension’, we don’t generally ask for 5% of it. But when the markets fall in value, which they will do, they fall by percentages – typically 10% or 20%, sometimes up to 50%. When you’re drawing down on top of that, you’re magnifying the loss. It’s the reverse of compound growth.
The 4% rule assumes you can draw down that proportion of your total fund annually. I think it’s fair and reasonable – I say 3.5-4% pa personally because investment returns are not fixed and could be slightly lower than expected. This amount can be reasonably drawn down if you have a 60% equity portfolio in your pension and you’re investing for the long-term.
How do I know how much I’ll need to retire?
A good way of looking at it is saying ‘OK, how much money do I spend now, and what expenses will continue through my retirement years?’ Some will stay the same plus inflation, and some won’t be there at all – we all hope to have paid off our mortgage before retiring for example. So you can look at the annual level of income you’re likely to need, as a guide. Then ask what your state pension is likely to be – here’s a calculator to help with that – and when you’re likely to start receiving it.
On top of that, look at any other pension arrangements you have now. Most people these days are a member of their workplace pension scheme thanks to auto-enrolment. Request a forecast from the pension providers on what your likely benefits are going to be at your chosen retirement date, but remember this is likely to be based on your current contributions continuing until that age. Make sure you’re forecasting everything to the same date, the same retirement age.
Now you can start to see what your income is likely to be, and you can decide if it’s sufficient or whether you want to make further contributions to increase your fund at retirement. Most people will need to make additional contributions: we tend to underestimate how much we’ll need for our retirement, remember it could be 40 years, as long as you have been working for.
An important note – before you start increasing any pension contributions, make sure you’ve cleared all your unsecured debt first.
How do I predict how long I’ll live, and therefore how much I need?
We’re making assumptions, so the probability is that you’re going to be wrong! But it’s better to have assumptions to work to than no planning at all. Remember that it’s a plan, not an absolute.
Actuarially our lifespan is typically 80-85 years old, but that’s just an average and you may live longer. With my clients, I assume they’ll live to 100, and with younger people now you may even want to go to 105 or 110 thanks to medical advancements and us being more health conscious than we were as a society. You don’t want to outlive your money, you want it to outlive you.
There’s a calculator here you can use, but remember, this is based on averages; you may not be average.
If you’re under-funded for your retirement I normally suggest to people that they should be putting away at least 12.5% of their income in their pensions – this reflects the first hour of a working day, but if you’re a late starter, say in your late 40s or 50s, then you may need to consider more than this.
If I’m approaching retirement in two or three years, what are the next steps?
It’s always important to go through the 5 Steps of The Money Plan.
- Set your goals. What does retirement look like for you? Where will you be living and what will you be doing?
- Get organised. Write down your expenses now and likely expenses in retirement. If you’re a keen golfer for example, if you plan to play more in retirement how much is that likely to cost you? Try to make your expenses as accurate as you can.
- Gather all the information you have on existing investments and policies. Get a state pension forecast, speak to your current providers and find out what you’re going to have in your pension fund. Is that income sufficient to meet your expenses? If not, you can only do two things: aggressively save more into your pension fund for a few years, or reduce your planned expenditure – maybe one cruise a year instead of two!
- Review your investment risk and start considering your options; annuity or drawdown, or a combination of both?
- If you need more money for your retirement, consider delaying your retirement plans – work gives us more than money, it provides us with a sense of purpose and I’ve seen people age quickly when that purpose, that identity, is taken away. It’s important to replace that purpose with something else, which could be charities, local community work or even continuing to work a day or two a week, or on a project basis.
Life is precious, and when retiring you’re approaching the final chapter; plan it, enjoy it and make it count.