In days gone by, when the vast majority of savers used their entire pension fund to buy an annuity income at the point of retirement, planning to mitigate the risk of a last-minute collapse in the value of the fund was routine. That’s not necessarily the case today because the assumption is that most people prefer to generate retirement income through an income-drawdown plan, where the pension fund remains invested.
That assumption is not unreasonable. Income drawdown plans are now more popular than annuities. However, thousands of savers still buy annuities each year – and with annuity rates up by a fifth this year, that number looks set to rise. Even those who opt for drawdown plans early in retirement often purchase an annuity later on.
Moreover, this year’s volatility has been a reminder of the havoc stockmarkets can wreak on savers’ plans. US shares fell 20% during the first six months of the year; parts of the UK market suffered similar setbacks. If you began the year largely invested in equities and with plans to retire this summer based on an annuity purchase, the corrections will have come as quite a shock.
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The traditional way to head off risk is to begin shifting your pension fund saving out of equities well ahead of retirement. Many pension providers offer “lifestyle” investment strategies that automatically begin to move your money out of equities around ten years before your target retirement date. You then continue down this “glide path” until you have little or no exposure to equities – typically five years out from retirement.
Consider all your options
There are some problems with this approach. First, most lifestyle plans depend heavily on fixed-income assets. But in the current environment, where interest rates are expected to continue rising, a shift out of equities into bonds may be a case of jumping out of the fire and into the frying pan.
Furthermore, many savers who take out lifestyle plans set a retirement date when they first begin saving and then forget all about the arrangement. Their retirement date may change later on, but the plan proceeds on the basis of the original target. That may expose savers to too much risk if they now plan to retire earlier – or too little if they now expect to cash in their pension fund later.
For these reasons, a more bespoke approach to managing risk in the run-up to retirement makes sense. If an annuity is likely to figure in your retirement plans, it is a good idea to lock in some of the gains you’ve made on your pension savings, but there are many ways to do that in practice.
Shifting from equities to bonds feels too crude. A wide range of asset classes and investment strategies now offer good risk-management potential. For instance, infrastructure assets provide good inflation-proofing features and real estate has a role to play for many savers too. Multi-asset funds, including the “flexible” investment trusts that can invest across asset classes, may be a good option for many.
Also keep in mind that the choice between purchasing an annuity and income drawdown does not have to be a case of choosing either one or the other. There’s nothing to stop you using some of your pension fund to buy an annuity while investing the rest in a drawdown plan. That could be a good compromise, but you’ll need to think differently about each pot of savings ahead of time. If in doubt, take independent financial advice on pension saving. Even experienced investors struggle with managing risk effectively – and trying to maximise the value of your fund for a set point in time can be challenging.
David Prosser is a regular MoneyWeek columnist, writing on small business and entrepreneurship, as well as pensions and other forms of tax-efficient savings and investments. David has been a financial journalist for almost 30 years, specialising initially in personal finance, and then in broader business coverage. He has worked for national newspaper groups including The Financial Times, The Guardian and Observer, Express Newspapers and, most recently, The Independent, where he served for more than three years as business editor.
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