Loading Conversation
What are my pension retirement options?
Monday 12th April, 2021
I am frequently asked by retiring client's, "What can I do with my pension pot?"
This is a crucial question, because since the implementation of pension freedoms there are several options for using your pension. Whether as a cash lump sum, annuity or flexi-access drawdown, the world is your oyster when it comes to accessing money from your pension pot.
However, there are many misconceptions around the options for cashing in your pension. Theses incorrect notions can be detrimental, as the decisions you make now will impact the success of your retirement in later years. It is therefore crucial that you understand all the possibilities. The guide below will provide you with a breakdown of the two most common retirement options and some strategies you can apply to help you make the most of your pension income.
Pensions are a wonderfully misunderstood beast. There are several misconceptions and misunderstandings, and this post is not broad enough to cover all of them.
When used properly, pensions provide:
- fantastic tax relief
- growth in a largely tax-free environment
- a 25% tax free lump sum that can be taken at once or in increments
- the ability, upon death, to pass the residual pension on to beneficiaries, free from Inheritance tax
Despite these benefits, they remain largely misunderstood. I will focus here on what the options are when you take your defined contribution pension. Final Salary pensions are a whole different kettle of fish, so I have decided not to cover them in this post.
When it comes to retiring the two main pension options are to purchase an annuity or utilise drawdown.
Option 1: An annuity
Here the pension fund is used to purchase an annuity, which provides a fixed income for an agreed period. This offers security of income; however, annuity rates are incredibly low, and the capital and income are generally lost upon death. Any additional features like inflation protection or capital guarantees reduce the income on offer.
In short, annuities offer real security for those who want absolute certainty around their income. The downside is that, due to low rates, a large amount of money is required to purchase a relatively modest income. Furthermore, as a general rule, the income stops upon death of the retiring person and the full lump sum used to purchase the income is lost.
Inflation risk
In my view, the greatest risk when purchasing an annuity, is the impact of inflation. Many people accept a fixed level of income when they buy their annuity. This means that the income does not increase in line with inflation each year. When you consider that the average person may live to age 88/89, the impact of inflation on their ability to make ends meet over time can be massive.
Risk to surviving spouse
Another risk is tied in with the fact that an annuity income quite often dies with the annuitant. If a married couple is relying almost entirely on the annuitant’s income to make ends meet, the surviving spouse can be left in a terrible financial position when both the annuitant’s state pension and annuity dies suddenly with them.
The annuitant can take steps to purchase inflation protection, or a spousal pension, or other options to mitigate some of the short comings mentioned above, but all of these will reduce the income they are able to purchase.
In order to demonstrate the impact of purchasing additional protections with your annuity, we did a few comparisons. In running these comparisons, we wanted to look at the impact of the three main annuity options on the income the annuitant receives. These options are:
- Purchase a level annuity income with no spousal pension, which remains the same for the life of the annuitant
- Purchase a level annuity with a spousal pension. This option allows for the spouse to continue receiving a percentage of the annuity income after the annuitant has died. We have decided on a 50% spousal pension. So, the surviving spouse will continue to receive 50% of the annuity income upon death of the annuitant.
- Purchase inflation protection. With this protection, the annuity income will increase in line with inflation each year, in order to maintain the real value of the income. We have decided that we would buy an annuity that tracks the Retail Price Index of inflation (RPI). For the purposes of this comparison, we have used an inflation rate of 2% per annum. The reality is that inflation will be both higher and lower than this over time, but we considered this a reasonable estimate, given the Bank of England’s current CPI target.
To demonstrate the impact of the above options, we created a client and his wife (Mr and Mrs Bloggs). They are both aged 65. Mr. Bloggs has a pension of £500,000. He is planning to take out his £125,000 tax free cash and use the remaining £375,000 to purchase an annuity. He has no health issues.
These are the results of the quotes:
- Level income – no spousal pension - £18,264
- Level income with spousal pension – spousal pension of 50% - £17,104
- Indexed (inflation protected) income – no spousal pension - £10,470
As we can see, the impact of the spousal pension is not overly dramatic. There is a drop of initial income of about 6.35% (£1,160) per year. Over 30 years this will amount to a difference in income received of approximately £34,800 between the level income and the level pension with spousal benefit.
However, the impact of the indexed income relative to the level income (no spousal pension) is substantial. The indexed income at outset is £7,794 per annum lower than the level annuity with no spousal benefit. The income will increase each year by 2% (our assumed rate of RPI inflation) and we have shown the impact of this over 30 years in the graph below:
As you can see, if the indexed income were to grow by 2% per annum, it would take almost 28 years for it to reach the starting level of the level annuity without a spousal pension. This would result in a difference in income received of approximately £123,000 over the 28-year period.
Now, this is simply a hypothetical demonstration. Inflation will not be 2% per annum every year for the next 30 years. It isn’t that now! The purpose of this exercise is to demonstrate that, while indexation makes absolute sense in theory, you really need to think about all the implications of the reduction in income before following that course of action. It makes sense to take advice to make sure you make the right decision.
Option 2: Flexi Access Drawdown
Here the pension pot remains invested and continues to grow. The pension holder draws income from the funds invested within the pension. This allows income flexibility and the ability to pass the residual pension on to loved ones upon death, free from Inheritance Tax. Unfortunately, the retiree carries all the investment risk and may see their pension eroded partially or completely over time.
This risk cannot be downplayed. It is important to note that drawing down an income from a pension in a bear market will exacerbate the overall negative impact on the value of the funds and will increase the time it takes to recover. Remember, if you lose 50% value of you pension in a bear market, you will need to generate 100% just to get back to where you were at the start of the fall.
One of the biggest risks to your retirement income is called “sequence risk”, which relates to the impact of making withdrawals during a bear market. Sequence risk refers to the risk that comes from the order in which your investment returns occur. If markets decline significantly in the first years of your retirement, and you continue to withdraw from the pension, then this will have a significant impact on the longevity of your withdrawal strategy. However, if you have very good returns during your first few years of retirement, then this can greatly improve the likelihood of your withdrawal strategy succeeding. In his book “Beyond the 4% rule” Abraham Okusanya concludes that, “Returns in the first decade of retirement is the main driver of sustainable income over the entire 30-year period. And the way you draw income from your retirement portfolio needs to be carefully managed, particularly in the early part of retirement.”
Pension withdrawal strategies
There are a number of strategies that can be applied to provide greater certainty about the level of withdrawals you can make without exhausting your pension provision prematurely.
The safe withdrawal rate for retirement
One of these is by application of a safe withdrawal rate. By this we mean the rate at which an investor can erode their capital (for income in retirement, for example) at a ‘safe’ pace. That is to say, the funds should not run out before the retiree dies. William Bengen estimated this rate to be 4% in the US, while Wade Pfau estimated it to be 3.05% in the UK. The starting level of income is increased in line with inflation each year, regardless of the performance of the underlying investments. Based on worst-case historical market conditions, a pension should last for 30 years. However, in most scenarios, at this rate you actually end up with more money than you started with. It also needs to be remembered that the above rates from Bengen and Pfau do not include the impact of fees, which can further reduce the safe withdrawal rate down to between 2% - 2.6% depending on the levels being charged.
At the end of the day, this method is a bit one size fits all and amounts to playing chicken with market conditions and the value of your eroding pension. However, it does form a useful basis upon which to build a more considered withdrawal strategy.
Guyton Guardrail for safe pension withdrawals
Using the safe withdrawal rate as a guideline, there are other strategies that can be applied, which will allow you to withdraw from your pension at a higher rate and still retain a good chance of not totally eroding your capital. One of these is the Guyton Guardrails, which rely on a number of steps to mitigate the impact of withdrawals on the pension value. These include not increasing the withdrawal in line with inflation in years following a negative performance. It also takes steps to meet withdrawals from the proceeds of best performing asset classes and skim off any excess returns into cash, as a reserve to meet next year’s withdrawal.
Natural retirement income from dividends and interest
Some people believe that they have found a silver bullet that mitigates the risk of eroding their pension capital in retirement. They will simply live on the natural yield (dividends and interest payments) from their pension portfolio. This way they avoid eroding their underlying capital. This is a nice idea in theory, however, in practice it is completely impractical for the following reasons:
- Natural income is unlikely to be high enough to meet most retiree’s requirements
- Dividend and bond yields go up and down like a yoyo, which will result in a constantly fluctuating retirement income that cannot be relied upon.
This is a strategy likely to only work for those who have substantial pensions and can generate a high level of income despite low or fluctuating yields.
It is therefore sensible, in most circumstances to use a total return withdrawal strategy, which draws down from both the natural yield, as well as the underlying capital. This provides greater stability and control of the income.
Modern Retirement Theory for pension provision
This theory relies on a combination of both annuity income and drawdown. The principle here is to put safety first and ensure that you have secure income in place to meet your essential expenses for the rest of your life. In order to provide this income, you need to utilise guaranteed income sources like a lifetime annuity. As the path of life and expenditure is not certain, the next step is to put in place a cash contingency fund, that can be used to meet any unexpected expenditure.
Only once these provisions have been put into place, should the retiree consider putting in place a volatile portfolio to fund any discretionary expenditure.
This is a very much safety-first approach, and in the UK, it is potentially possible to model this approach around any final salary or state pension income, as at least some of the secure income.
Spending trends for retirees
Lastly, as part of your planning, you also need to take consideration of the way your spending patterns are likely to change during retirement. According to the International Longevity Centre(ILC) (Understanding Retirement Journeys: Expectations vs reality - ILCUK), people spend less and less on consumption, as they get older. They found that a household headed by someone aged 80 and over spends, on average, 43% less than a household headed by a 50-year-old. In addition, they found that many older households continue saving throughout retirement. Individuals aged 80 and over are saving, on average, around £5,870 per year. Much of this is down to health issues restricting retirees from travelling as much as they used to or carrying out the activities that they would most like to do.
All of this is counterintuitive. In many ways we have been taught that retirement spending is u-shaped – with higher spending at the beginning and end and a bit of a drop in the middle - when in reality there is no evidence of an increase in expenditure in later years. Admittedly, for those who do go into care, there is a substantial increase in costs, however in 2016 the Age UK Later Life in the UK study found that only 16% of over 85s actually live in care homes. The reality is that the majority receive care and treatment at home, thus keeping costs lower.
Now, I am not saying that you shouldn’t plan for going into care, but I think you need to also consider the facts of what is actually happening when developing your retirement strategy.
Final thoughts: Annuities versus Drawdown
This remains a very complex area of advice and the complexity is often underplayed by many. It is crucial that you determine what your retirement strategy is going to be at the outset, how you will use your pension, and how you will respond to different scenarios.
This is where an experienced pension adviser can really add value, by helping you put in place a plan, helping you to put together a suitable investment plan and then helping you implement the necessary steps each year to keep you on track.