Most avid Money Observer readers will know that they should not rush straight into buying the first annuity they are offered on retirement because a much better deal will invariably be available if they shop around, particularly if they are not in the best of health.
What most readers may not know is that there will soon be another option at retirement – to invest your pension pot in a bridging fund that pays an income until you decide what to do with it – and this has many very real advantages.
A key attraction of investing your pot into an income-paying fund for the first few years of your retirement is that you can avoid buying an annuity at the current desperately low market rates.
A second key benefit is that if you die in the first few years of retirement, your spouse or dependants will receive your remaining fund (subject to 55 per cent tax if it is paid as a lump sum). This is a significant factor bearing in mind that they would receive nothing if you buy a single life annuity, which is still the most popular selection made today.
The third and least widely appreciated advantage is that your fund is invested in the markets for a longer period so enabling it to grow in value and ultimately generate more income in retirement. This can substantially transform your future income because your pension pot should be at its largest size at the point of retirement and is therefore able to generate bigger returns.
As an example, in final salary schemes, where pensions are paid from a fund that is continually invested, 30 per cent of the benefits are generated from pre-retirement investment and a massive 60 per cent comes from post-retirement investment returns. The other 10 per cent is simply the original contributions.
This is critical because people continue to live longer. For example, a man retiring today has a 10 per cent chance of living past 100. With retirement extending past 20, or even 30 years, it makes no financial sense to force a pension fund to forgo years of potential growth, particularly if in a few years we enter a period of higher inflation.
There are other good reasons for delaying an annuity purchase. In practice, at the time they retire most people actually know little about how the next 20-30 years of their lives will pan out.
The statistics on the matter are fairly grizzly. For example, most people enter retirement as one half of a couple but in 60-70 per cent of cases, one person outlives the other by a surprising 10 years. Divorce post-retirement is also on the increase. Furthermore, in the first 10 years of retirement you are three times more likely to develop diseases such as cancer, heart problems or dementia that may lead to premature death, than in the years leading up to becoming a pensioner.
Typically, a great deal of insight into your health, life expectancy and potential lifestyle is gained in those first years of retirement. Buying an annuity is still generally the best option for most investors, providing a regular, guaranteed worry-free income for later years. However, it ties up your money for good, leaving no room for manoeuvre. Delaying annuity purchase means that you should be able to select the plan – joint or single life for example – that best suits your circumstances.
‘Retirement should be the start of a great adventure,’ says David Hutchins, UK head of defined contribution investments at AllianceBernstein, an investment company that is planning the launch of a ‘retirement bridge’ fund later this year.
‘Forcing them into making the biggest financial decision of their life in one day is not sensible; it helps if they are allowed to settle down and then they can begin to understand their needs. Pensions are complicated and there are not many role models – the parents of people retiring today may have retired 20-30 years ago and are anyway a poor example of potential longevity as people are living so much longer.
‘Our research showed that a lot of the time people buy the first annuity they are offered simply because they need an income or pay cheque in the next month, and they have not thought it all through.’
However, you cannot simply buy a pension bridging fund with your pension pot and take money out at will whenever you need it. HM Revenue & Custom’s quid pro quo for the tax breaks you received on your pension investment is that you do not use it all up prematurely and fall back onto state welfare. There are strict guidelines about how much you can withdraw from your pot every year based on factors such as your age, gender, the size of your pension pot and the current gilt index yield. An easy reckoner can be found at www.invidion.co.uk/pension_fund_withdrawal_calculator.php.
Traditional income drawdown arrangements are monitored by specialist pension advisers and the charges can be too high for someone with an average-sized pot. These new retirement bridge funds, often dubbed ‘pensions drawdown lite’ arrangements, are designed to be arranged by employers or by master trust arrangements (pooled pension pots that can be run by trade organisations or investment companies), which even someone with modest pension savings can buy into.
Under a traditional drawdown arrangement run by a specialist adviser, you would typically pay an annual charge of 1 per cent, plus a set fee of perhaps £250 per year, for advice such as monitoring income levels. In fact, figures from AllianceBernstein reveal that for the average £25,000 fund, the annual £250 fee for advice that initially equates to 1 per cent will actually rise over time to more than 2 per cent by the 10th year as a fund managed in the traditional way is depleted by other charges.
Another important factor is ‘mortality drag’, the term used to describe the percentage the fund must continue to grow by to be able to purchase the same level of annuity as it would have purchased at the investor’s retirement date. AllianceBernstein calculates that for a fund of £25,000, using a traditional charging structure, the mortality drag starts at 0.3 per cent but rises to 1 per cent by year 10. Consequently, the average investor’s fund of £25,000 will have to grow by more than 3 per cent per year to achieve any real growth.
Without the traditional high charges, an investor with a £25,000 pot would need only to achieve an annual return of 0.5 per cent over bonds for their fund to grow at a pace at which it continues to purchase the same level of annuity as it could have purchased at the retirement date. This level of return could be achieved by having as little as 10 per cent in risky assets, AllianceBernstein claims. However, in comparison, an income drawdown arrangement with a traditional penal charging structure would have to take risky bets with 70 per cent of an investor’s portfolio to be able to maintain its annuity purchasing power, something very small investors would not have the appetite for.
Pension bridge fund arrangements are still in their infancy. Providers with multi-asset expertise are considering using mixed asset funds to engineer low-risk funds for bridging owing to the stability provided by the diversification of the assets, although for this purpose they would make a higher allocation to bonds to provide additional security. Specialists in the pension liability-matching market are also interested in this market and have low-risk pooled funds that are currently aimed at small pension schemes but could be rolled out to a broader retail market.
Standard Life, for example, already offers such funds to employers and pension scheme sponsors, for use as their scheme members retire. One option is its low-risk Absolute Return Global Bond fund or there are a range of risk-based investment solutions under its MyFolio range of risk-based portfolios, which offer a choice of investment strategies across five risk levels.
AllianceBernstein’s approach is based on a series of pooled low-cost tracker funds exposed to assets such as shares and bonds that would come to fruition at various dates in the future. It plans to charge no more than 1 per cent for this ‘off-the-peg’ fund.
Managed risk drawdown service
Milton Keynes-based independent adviser Retirement Angels is launching a ‘managed risk drawdown service’ in September. This low-cost income drawdown arrangement will identify how much money an investor can safely spend in retirement while maximising the chances of meeting other objectives such as care in later life or to support family after death. The investor’s individual risk appetite is then used to calculate the best allocation of pension assets across a range of passive funds, run by the US company Vanguard.
Alan Higham, founding director, says a client with a £250,000 pension fund taking drawdown at age 65 and buying an annuity at age 75 will pay charges of just 0.8 per cent per annum over the 10 years, based on a 0.3 per cent fund management charge; 0.18 per cent outsourced pension administration fee; a 0.03 per cent fee to set up and provide ongoing communications; and advice at 0.29 per cent per annum.
Higham says that in addition to the desirability of delaying annuity purchase until gilt yields bounce back to more normal levels, there is an appetite for switching cash out of pension tax wrappers and into Isas to avoid any potential government change to pension tax benefits. Some investors will also benefit from switching cash into an Isa in the name of a lower-tax paying partner.