The Budget has paved the way for the biggest shake-up in pensions for generations – perhaps ever. From April next year, most restrictions on pensions will be removed.
If you want to, you can withdraw all of your pension in one go. No more rules on how much you can draw down each year, or being forced to tie yourself into an annuity.
An annuity may still be right for you, of course. They have one big advantage over income draw down – you will never run out of money. But it does seem likely that annuities will be shunned by many investors, at least unless and until they offer better value.
However, if you plan to take charge of your own money in retirement, you need to think hard about two things: how to build up your savings pot, and how to invest once you have retired; because what previously passed for conventional wisdom may no longer be appropriate for most people.
The end of ‘life-cycle investing’
For most of us, final salary pensions – where you are guaranteed a certain retirement income by your employer – are long gone. Most company pensions and all private pensions are now ‘defined contribution’ or ‘money purchase’ schemes.
With these, the amount of money you have in retirement boils down to how much you can save and the level of returns you get on those savings.
Before the Budget, on retirement lots of people handed over 75% of their pot (having taken 25% as a tax-free lump sum) to an insurance company in return for an annuity, which provided an income for life. This in turn had a huge impact on how pension funds were invested.
You had a target retirement date, on which you handed over your life’s savings in a one-time deal to secure the best annual income you could. The last thing you wanted was to be hit by a 2008-style stock-market crash the day before you made that trade.
This fear of losing a big chunk of money near retirement has led to what is known as ‘life-cycle investing’. Under this strategy, the closer you get to retirement, the more money you put into less volatile investments such as bonds, so that if the stock market crashes, your savings probably wouldn’t suffer too much.
Life-cycle funds have become popular and many company pensions are run this way. But if you are not going to buy an annuity to fund your retirement, then life cycle investing may not be the best strategy.
A rethink is needed
You see, unless you are lucky enough to have a very big fund and can just draw down the cash you need every year, you are going to have to invest your money.
You have to ensure you have enough to live on from day to day, while also making sure you don’t run out before you die. It’s possible you could live for 30 to 40 years after you have retired, so you may have a lengthy time horizon to plan for.
It’s easy to see why lots of retired people like bonds. Their income is predictable, as is the amount of cash you get back when they mature. They feel safe. The trouble is that most bonds won’t pay an income that rises with inflation. Even 3% annual inflation will reduce the buying power of £100 to £74.50 after ten years, and £41 after 30 years.
Unless you can afford to see your buying power slide like this, you really need your investments to offer some protection from inflation. This means most of us can’t afford to have our whole savings pots in bonds or cash. You need a portfolio with investments such as index-linked bonds, property and shares.
It can be hard to wrap your head around this, as it’s been ingrained into most of us that older people should stay away from shares. They bounce around too much (they’re volatile), which makes them too risky. In the short run, this is a reasonable view. But for an investment horizon of 30-40 years, it’s not.
With equities, time is your friend
Historically, most older people have seen their investment time horizon as being short – it was simply how long they had to go before they retired and cashed in their pot. The new pension rules change this.
Now you could have 30 to 40 years to invest over. So you need to consider what you are most afraid of. The ups and downs of the stock market? Or inflation eating away at your money? The answer will decide your strategy and influence the amount of money you will have each year.
Shares have in the past done a good job of protecting your money from moderate inflation. Productive businesses tend to be able to increase their prices and dividend payouts in line with inflation, which in turn can protect the capital value of the shares. The longer you own shares, the less volatile they are – time allows the good years to offset bad ones.
There were big stock-market falls in 1987, 2003 and 2009, but people who held on saw their investments quickly recover while dividend payments for many firms were held or increased.
The Barclays Equity Gilt study shows that over holding periods of 20 years or more, the minimum return on equities has always beaten that from bonds and cash. While the past may not repeat, holding shares for 18 years has a probability of beating cash 99% of the time and bonds 88% of the time – well within the time horizon of most retirees.
What should you do?
While having all your money in shares doesn’t make sense, having 50% in them might not be a bad idea as part of a balanced portfolio. You could do this by building a portfolio of high-yielding shares, or via an equity income fund or dividend exchange-traded fund (ETF). Or you could look to invest in high-quality firms that have a proven track record of delivering over the years. This is the Warren Buffett approach to investing.
In the UK, Terry Smith’s Fundsmith fund follows a similar strategy. But perhaps the main lesson is, if you’re not going to buy an annuity, you must stop thinking like someone who is near the end of their investing life. Realistically, you might be somewhere in the middle.