Pension changes mean you need to take charge of your retirement, says David C Stevenson.
The changes made for savers in this year’s Budget – freeing up pensions and increasing Individual Savings Account (Isa) allowances – are great news. But they do mean that older investors need to think hard about how to invest for the future.
Annuities were, and in many cases still are, wonderful devices that give retirees the two things they crave most: certainty of income and simplicity. Say you are a 65-year old male about to retire. If you paid £100,000 for a single-life policy with level payouts (ie, not adjusted for inflation) from the “average” annuity provider, you’d be looking at a £6,065 annual income.
Many investors will convert that number into what is in effect an income yardstick – ie, they’ll think of it as a 6% annual return.
But it isn’t really an income. The annuity provider is in part paying that ‘income’ from the capital invested – at the end of the investor’s life, there will be nothing left to pass on.
There’s also the lack of protection against inflation, which as we know is a given in modern societies. If we use our £100,000 to buy an annuity that includes a 3% inflation escalation, our annual payout (not ‘income’) falls to just £4,126. And current low inflation rates (below 3%) may not stay that way.
My own hunch is that we should plan for a worst-case scenario over the next 30 years, of an average of 3.5% to 4% a year.
Annuity rates are also hugely affected by life expectancy. While women live longer than men, and people in wealthy areas live longer than those in poor areas, longevity in general is rising. This matters because insurers use longevity data to estimate how much money they can afford to pay out as an annuity. The longer we live, the lower the rates.
Government bond rates also matter. Put simply, the lower bond yields are, the lower annuity rates.
Put it all together and you have a perfect storm for 65-year-old retirees – they’re living longer, at a time of low interest rates and still-pervasive inflation, and more and more of them want to preserve some capital to pass to their children.
All of this complexity now falls on the shoulders of the ordinary investor – so it’s important that you think about how you are going to deal with it. Make the wrong decisions about what to invest in and you could incur huge capital losses, which could force you to rely on the state’s largesse.
So what should an average 65-year-old do with their pot? It depends on your circumstances (obviously), but it is reasonable to assume that you’ll want as much regular income as possible, with some inflation protection and the possibility of some capital left over (though you’ll need realistic expectations as to how small this might be).
Annuities can still make sense and I wouldn’t ignore them as part of your planning process. They give certainty and regular payments, even if they don’t preserve your wealth.
They also contain a (terrible) implicit subsidy, which is that wealthier investors with longer life expectancies are subsidised by poorer investors with shorter life expectancies. I think that’s a scandal – but as fewer people buy annuities, this subsidy will start to vanish.
The next alternative is to do your own version of an annuity. This involves sticking your £100,000 – which would have gone into an annuity – into 20-year UK government gilts, currently paying around 3.3% a year.
I’ve done a simple spreadsheet which you can access here, which shows a plan based on withdrawing £6,000 at the start of each year, then rolling the interest (at 3.3%) into a cash fund that pays out after the gilts have been sold (in effect, we’re selling £6,000 of gilts a year to fund that annual payment).
I’ve assumed no trading costs, no reinvestment back into gilts, no yield on the accumulated cash from gilt interest payments, and that you use a 20-year gilt to expiry.
By my calculations, our 65-year-old runs out of gilts to produce an income after 16 years (aged 81), at which point they draw down on their cash from accumulated interest. By 85 they are down to their last £5,872 on a yield of 3.3% a year. So if they live beyond 85 – an increasing possibility for many wealthier investors – they’ll have run out of money.
Other observations to make are that if gilt rates fall to 2.5% (unlikely, but not impossible), our pensioner runs out of money at 84, whereas if 20-year rates climb back to historic averages of near 4.5%, they can probably last out to around 88.
But there are two problems here. Firstly, you have no inflation protection – you are just withdrawing a flat £6,000 a year. Secondly, you still have no money left at the end to pass on to your children. What to do? I think it is possible to do three different things via one portfolio, all of which might help improve your income flow and build a solid, robust financial base.
The first is to use a diversified set of funds that produce a decent income of 5%–6% a year without taking extravagant risks. Secondly, you need inflation protection too, which is why you might need to think about moving some of your accumulated wealth away from conventional fixed-income securities (bonds) into a variety of assets ranging from index-linked gilts through to equities.
Finally, we’re also looking for funds that allow easy and almost instant re-investment of any income so that you can replenish your capital over time.
I’ll look at how to do this in my next article, in a fortnight’s time.