Freedom and choice: Working through the pensions maze

Fidelity’s Richard Parkin describes how best to navigate the ‘pensions maze’ presented by freedom and choice

It’s great that pensions and retirement has become a central topic for mainstream media.

When we see the red tops providing pull-out guides to pension freedom we can be sure that pensions are starting to capture people’s imaginations in ways we could never have dreamed of.

Inevitably though, distilling what is still a very complex subject into digestible media stories can mean some nuanced but very important points are missed.

Here are some of the ones that we’ve noticed and why we think they’re important.

Blending income sources

Too often we see retirement planning being presented as a simple choice. Take cash, buy an annuity or go into drawdown. In reality, for most people, the best result will be to combine different income sources to meet their individual needs.

A good retirement plan needs to balance a number of, often conflicting, priorities:

• Maximising income while ensuring it remains stable
• Retaining flexibility while guaranteeing a lifetime income
• Enjoying retirement while providing for loved ones when you’re gone

No product has been created that can do all of these things, though I suspect some may claim they’ve come close.

In practice, satisfying all of these needs can be done by mixing annuities and drawdown with state pensions and defined benefit pensions.

The other advantage of blending multiple products rather than buying a single bundled solution is that you can get best of class for each.

Given the focus on shopping around for an annuity, advisers should take care before recommending a bundled offering that isn’t getting the very best deal for the customer.

The case for guaranteed income

I know it’s deeply unfashionable to suggest buying annuities but we do see a very important role for guaranteed income.

Having sufficient guaranteed income to cover essential expenses is something that makes sense for a couple of reasons.

The first is that it helps people sleep at night knowing that whatever happens they have somewhere to live and something to eat.

Secondly, and more subtly, it allows them to take on a greater level of investment risk and so increase their chances of achieving their retirement goals.

I am concerned that the dash away from annuities will have people going into drawdown but adopting a very cautious investment strategy.

If we can give people the certainty that their essential expenses will always be met then they may feel more inclined to take on investment risk and, therefore, make drawdown really worthwhile.

Annuities aren’t the only source of guaranteed income

While annuities may be the only product that provides guaranteed lifetime income, they certainly aren’t the only source of such income.

Many people will have defined benefit pensions and most will have the state pension.

In the case of the state pension, retirees benefit from the triple lock that ensures their pensions increase in line with inflation, earnings or 2.5% each year; whichever is higher.

You generally can’t buy additional defined benefit pension but you can increase your state pension by deferring state pension and using your retirement savings to fund current income.

The terms for doing this are particularly favourable for those reaching state pension age before April 2016 but it may also be worth considering after this time.

Some are wary of this option. Customers feel that having paid their National Insurance they want the pension they’re entitled to while others focus on the fact that this only works if you live for a long time.

But the comparison should be made with purchasing an inflation-linked annuity against which it stacks up very well.

Drawdown – one product, many uses

Something else I hear a lot is people talking about drawdown as a generic product.

It is an incredibly powerful product that can support a wide range of retirement income strategies from passing pension money to the next generation to rapid withdrawal over a short period to creating a regular sustainable income.

The choice of withdrawal strategy will have a significant influence on the investment strategy to be followed. I often hear from advisers and customers that they intend to follow the same investment strategy in decumulation as they used in accumulation.

This can work but it can often expose customers to unnecessary risks.

Using growth oriented funds to support regular withdrawals can be very risky unless they are volatility controlled.

We favour funds that can generate a sustainable and growing income but also have a strong focus on limiting downside risk. Not considering volatility increases the risk that market falls are compounded by capital withdrawals quickly leading to money running out.

Running out of money might not be the problem

Running out of money in drawdown is a risk but how likely is it in practice? We may have a bigger problem, namely that people don’t take the income they need or deserve because they’re too scared of running out of money.

Say what you like about annuities, they’re efficient at ensuring capital gets distributed to the current generation of policyholders.

Drawdown is different as there’s no pooling of capital and risk so individuals are on their own.

Experience from Fidelity Investments in the US suggests that faced with this, customers tend to become very conservative in their withdrawal strategy. There’s a great opportunity for advisers to help people understand how they can spend money safely and make the most of their retirement savings while they’re alive.

In summary then, it’s great that so many people are talking about pensions. But we need to make sure that we don’t dumb the issues down to the extent that mistakes are made.

The need for informed and accessible retirement advice has never been stronger.

Richard Parkin is head of retirement at Fidelity Worldwide Investment