What does Brexit mean for annuities, drawdown and final salary?

In the long run-up to the European Union (EU) referendum vote, there were plenty of stern warnings from the 'remain' camp that a post-Brexit world would be a much bleaker one for pension-holders.

Unsurprisingly, those who campaigned for 'team leave' argued the opposite, instead claiming the fears had no foundations and were simply a scaremongering tactic.

So is it a case of business as usual, or will there be consequences for pensions? Below Money Observer looks at how the Brexit vote could impact investors and retirees in a range of different pension types.

STATE PENSION

First things first: let's consider the state pension, which one might assume out of all the pension types is in the strongest position, given that its funding is not at the mercy of financial markets' fortunes.

Over the short term there is nothing to worry about, according to Malcolm McLean, senior consultant at pensions consultancy Barnett Waddingham.

He says those who have retired will not see their state pensions cut, even in the event of the UK entering recession, which various economists expect will happen.

'In terms of the chances of the state pension being cut, Britain's economy would have to be as bad as Greece's for politicians to consider such a move,' he comments.

Instead, it is the younger generation who will be worse off from any future changes. In a worst-case scenario, taxes could rise in the future to keep funding the state pension at its current level.

But the days of the 'triple lock', which guarantees annual increases in the state pension, may be numbered. Under the triple lock, the state pension will rise each year by at least 2.5 per cent, the rate of inflation or growth in earnings - whichever is highest.

Before the referendum, former prime minister David Cameron said he would consider axing this 'special protection' because a Brexit would leave a big shortfall in public finances.

Recently, former pensions minister Ros Altmann said it should be turned into a 'double lock', based on earnings and inflation, which would 'save billions of pounds'.

McLean comments: 'The triple lock is viewed as unaffordable in the long term, but I would expect it to remain in place until 2020, which the Conservative Party committed to in its 2015 election manifesto.

But Steve Webb, the former pension minister and now policy director at Royal London, expects the triple lock to remain protected.

'There is no doubt that we are entering a period of great uncertainty. More immediately for today's pensioners, there may be concerns about threats to the triple lock on the state pension, but it would be odd for a government to prioritise a cut which would affect the most powerful voting bloc in the country,' he says.

FINAL SALARY SCHEMES

The deficit of final salary or defined benefit pension schemes, which is linked to the financial health of the employer backing the scheme, reached a record high of £935 billion shortly after the EU referendum, according to actuarial firm Hymans Robertson.

Volatile equity markets are to blame, as well as the fact that gilt yields remain stubbornly low, with the benchmark 10-year UK government bond yield at the time of writing below 1 per cent for the first time. Before the EU referendum result the yield was 1.37 per cent.

Unless yields rise again, some schemes' funding will remain under pressure. In times of uncertainty nervous traders rush to snap up high-quality bonds, such as UK government bonds, which is why yields have fallen.

An interest rate cut, which is expected in the coming months, will result in government bonds remaining popular.

Conversely, an interest rate rise, which looks unlikely in the near future unless inflation flares up (as a protracted weaker pound makes imports more expensive), will cause gilt prices to fall and yields to rise.

Tom McPhail, head of retirement policy at Hargreaves Lansdown, points out: 'If the economy does now start to stall or even contract, then corporate profits will be hit, and this in turn could lead to further funding issues for employers.'

However, weaker sterling, which is 10 per cent lower versus the dollar since the EU referendum result, is a potential silver lining because it 'may help these businesses to export their way back to profitability'.

McLean, on the other hand, plays down fears that employers could move quickly to change the benefits due from their final salary schemes, even if deficits continue to rise. He adds that cuts are always a last resort, and that schemes would move to increase member contributions first.

'Deficits were a problem before Brexit, and have been for some time. Not much has changed; deficits have simply become a bit bigger.

'Defined benefit schemes and trustees have had to cope with stock market falls in the past, so there is no immediate cause for concern. As always, the biggest risk is that the employer becomes insolvent,' he says.

WORKPLACE AND PERSONAL PENSION FUNDS

The more common pension type for those working today is a defined contribution scheme, where typically an employer will match the amount savers tuck away each month, up to a certain percentage.

The impact of Brexit for such scheme members will depend on how far away they are from retirement and where their money is invested.

Dealing first with the former, younger savers are better placed to stomach market volatility, which is widely expected to continue over the next couple of months, if not longer.

Experts say that because there are so many unknowns over the nature of Britain's economic relationship with the EU once the exit is complete, there will be financial market turbulence during the trade negotiations, which are expected to go on for at least two years from the point at which the formal process of exit is started; this itself could be months away.

Not only do pension contributors in their 20s, 30s and 40s have plenty of time to shake off losses, but they also benefit from investing regularly, with money taken from their salary and put into their pension on a monthly basis.

In doing so they are simply buying assets at cheaper prices when the market has fallen.

Most investors who are 15 years or more away from retirement are likely to have most or all of their pension pot in equities, whether they opted to invest in the 'default' fund or have been more proactive in selecting their own investments.

But experts stress that they should resist any urge to tinker, arguing that volatility is part and parcel of investing in stock markets and that over time equity markets recover, even when severe bear markets strike.

There is also another silver lining from sterling's depreciation, which should help to calm nerves.

While a lower pound is bad news for the UK's economy because it makes imports pricier and pushes consumers to tighten their belts rather than spending freely, it is a boon for internationally facing domestic companies because their exports are made cheaper, which will therefore boost their earnings.

Global shares, therefore, which tend to be a meaty part of the equity weighting in institutional pension strategies, will benefit from sterling's fall.

For those closer to retirement, however, there is less time to make up lost ground.

Lee Hollingworth, head of defined contribution consulting at actuarial firm Hymans Robertson, says that in the event of market volatility persisting, savers who had planned to retire in the near future - the next three to six months - may need to think about delaying.

'It is worth considering waiting until markets settle down. As history tells us, markets can quickly recover and win back their losses following a bad patch,' says Hollingworth.

But he adds that many savers who are 10 years or less away from retirement and are invested in the default 'lifestyle' pension fund option in their occupational scheme will have been cushioned by the fact that their pension is being progressively moved out of shares as retirement approaches, and instead comprises a mix of assets, including bonds and property.

This diversification should in theory better protect pension pots from market turbulence.

'Those who are in one of these funds will actually have benefited from the fact that bond prices have risen,' adds Hollingworth. 'But during uncertain times it is important to stay invested and hold your nerve, as opposed to rushing to cash in the pot early.'

DRAWDOWN

Since the pension freedoms were introduced in April 2015, growing numbers of people at retirement have opted to enter income drawdown schemes, whereby they can take sums directly out of their pension pot as income, while leaving the rest invested.

But in times of market turbulence the size of the pot tends to shrink. The message from the experts, again, is to keep a cool head, and that those who can afford to reduce withdrawals should consider doing so.

The danger is that withdrawals could eat into the capital base of the pension pot at a time when it is already depleted because of market movements.

People in drawdown are therefore advised to take the 'natural yield', which comprises only the actual income earned by investments - for example, dividends or the interest or 'coupon' paid by bonds.

'This means you are likely to generate an income of around 3 per cent to 4 per cent on your portfolio,' says McPhail.

Leaving the capital untouched reduces the risk of 'pound cost ravaging', a term that describes the negative effect of over-ambitious regular withdrawals if they are made after markets have fallen.

McPhail gives an example of how a falling market can do a lot of damage very quickly.

He explains that if a saver draws 6 per cent a year income from a pension pot that falls by 20 per cent in value in year one, before then growing by 4 per cent for the next nine years, the pot would at the end of 10 years be worth less than half its original value. In 20 years' time the pot would have been exhausted.

ANNUITIES

The fall in gilt yields is an unwelcome one for annuity providers, as most firms buy this type of bond to provide the fixed income they pay to policyholders. As a consequence, rates for those now purchasing an annuity are also affected.

Some annuity providers have already cut rates, including Legal & General, Aviva, Just Retirement and Retirement Advantage. The cuts have ranged between 2 and 3 per cent, so a healthy 65-year-old with £100,000 to buy an annuity will lose between £100 and £150 a year.

'For any investor planning to buy an annuity in the immediate future, it may make sense to do so sooner rather than later. Once you've obtained a quote from an annuity company, the terms are usually guaranteed for between two and four weeks,' says McPhail.

'As always, make sure you shop around for the most competitive terms for your personal circumstances before committing to an annuity deal.

'If you want to delay purchasing an annuity, but need to draw on your pension savings in the meantime, then look at drawing an income from your funds using a drawdown arrangement instead.'

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