Final salary schemes have provided secure income for retired employees for over 60 years with employers bearing the cost and risk of meeting the promised pension. Sadly, few employers can now bear that risk, or are unwilling to, unless of course the employer is the state.
Employees in the private sector and the self-employed bear all the risks associated with providing their pension in retirement.
When accumulating a pension pot the risks are mainly confined to under-funding and or poor investment choice but at retirement the risks increase significantly. So what are the key risks?
- Selecting an unsuitable retirement product
- Running out of funds prematurely
- Living too long
- Prolonged low or negative investment growth
- Sequential risk (making income withdrawals when markets are falling)
One way to counter these risks is to annuitise - purchase a secure income for life. Even though annuities have suffered some bad publicity around value for money, if secure income is essential to meet everyday living expenses and no other sources of income are available, annuities remain the most suitable retirement option.
Annuitising doesn’t eliminate all risks -
- The risk of locking into a low rate and low income
- The risk of locking into a product that can’t be changed even when personal circumstances may change significantly
- The risk of over-paying for inflation-proofing which could be achieved through investment growth
- The risk of purchasing too early - higher income can be achieved at older ages, particularly when health becomes a factor
- Purchasing an annuity can be deferred and bought in tranches when deemed better value (rates improve and or health deteriorates)
The risks in drawdown can be managed or mitigated to some extent.
- Sequential risk is potentially the most damaging in producing a bad outcome. Cashing in units to pay out income at a time when markets are falling can seriously deplete one’s pension pot. However, this can be partly mitigated by ensuring sufficient cash is held at all times to pay a regular income. The down side being holding too much cash lowers overall returns.
- Running out of funds prematurely can be managed by ensuring withdrawals are kept below 4% and monitoring the investment performance.
- Living beyond the average mortality age should be a cause of celebration but in financial terms this can be result in an unexpected depletion of funds - purchasing a deferred or fixed term annuity may help manage this scenario
- A prolonged down turn in global stock markets is less likely than this event in individual markets such as the FTSE, so having a global portfolio can help mitigate this particular risk.
- It is possible to protect capital by using protected funds that lock in gains but when stock markets are volatile the fund charges can be prohibitive.
- Funds can smooth out gains and losses in the same way as with profits and are popular as they take out the roller coaster type experience most investors dislike, but again costs can be an issue.
When it comes to choosing a retirement option it’s simply not that easy because each has its pros and cons, with different inherent risks. In truth individuals tend to get more conservative as they get older, so more cautious when investing. Unfortunately this tends to limit growth potential and therefore the ability to inflation-proof income so if inflation proofing is important then a more balanced portfolio may be better. In more recent years, having the facility to phase tax free cash and minimise tax has been high on a client’s needs list.
Summary of the features that most retirees value most
- Secure income for life
- A growing income that mitigates inflation
- The ability to phase tax free cash
- Value for money
What’s important to recognise is that individuals should be able to determine their priorities – how much secure income they need immediately and how much they feel comfortable investing. For some opting to inflation proof income through investment growth may be preferable than forgoing initial income from an annuity. Some flexibility may be given up in lieu of having income security.
Most retirees recognise that compromising to some extent will help them reach a good outcome. Whatever the choice, making it a stress-free experience, initially and later if changes are required is crucial to a good adviser client relationship.
Is there a readymade solution dealing with all these issues?
What if you could have annuity and drawdown in one wrapper, where clients can determine the proportion of annuity that suits and with the ability to add more secure income if and when appropriate? What if annuity income can be retained in the pension wrapper when it is no longer required and reinvested? Can investing be made straight forward with readymade solutions and can tax free cash be phased?
The Retirement Account has all of these important features and is available from Canada Life.
Nigel Orange, Technical Manager, Canada Life
Nigel is a pensions specialist with over 30 years in the industry spent with major life and pensions providers as a broker consultant and a product and distribution specialist.