The uncomfortable truth is that many people with defined contribution pension savings have an insufficient amount to provide a lifetime income to meet their requirements, says Bob Champion – so what should they do?
Most retirement income articles in the trade and popular press are written about converting pension savings into lifetime income. The trouble is – many of those with defined contribution pension savings have an insufficient amount to provide a lifetime income that meets their requirements.
So what do we expect them to do? Take their tax-free cash, buy an annuity or take drawdown with the balance and then live in hope?
Assume an individual has a State pension of £9,000 a year and a pension pot of £50,000. After drawing £12,500 tax-free cash, they are going to have £37,500 to secure that lifetime income. If they are targeting an annual income of £15,000 a year, for how long is their £50,000 going to sustain £6,000 a year withdrawals? They are looking for a withdrawal rate of 12% a year.
What happens in practice is that they draw down their £6,000 a year by either: topping up the annuity they purchase with drawings on their tax-free cash; using a combination of tax-free cash and income drawdown to meet their £6,000 a year spending needs; or making ad hoc withdrawals using Uncrystallised Funds Lump Sums to meet their spending needs.
Whatever action they take, between seven and 10 years into retirement they are going to face a serious income shortfall – and this is despite a prudent attitude to their retirement spending.
Many people in this position own their own home and, if they were to add £100,000 to their £50,000 pension savings through either downsizing or equity release, the withdrawal rate becomes 4% per annum, which becomes more achievable.
What if the pension savings were not looked upon as having to provide a lifetime income? If instead they were proactively invested to sustain an income of £6,000 for a period of say nine years, the picture changes again.
Then £100,000 could be released from the home. If housing wealth is the last port of call, and the client has a low-risk threshold, should we then be looking at buying a purchase life annuity? At the time of writing, current annuity rates would produce a lifetime income of around £6,500 a year, for a 74-year old (level income, five-year guarantee, no dependants’ pension).
Purchase life annuities have become the poor relations of the annuity market. Many years ago it was the norm to take some of the tax-free cash and use it to buy a purchase life annuity. This was because of the favourable tax treatment of purchase life annuities over pension income or annuities secured by proceeds of pension schemes.
Under a purchase life annuity the notional return of capital is not taxed. The older you are when the annuity is purchased, the greater the proportion of each instalment that is tax-free.
At current rates, however, purchase life annuities bought when the annuitant is in their 70s do not produce a taxable element. Even if they did, recent changes to savings income tax would make it highly unlikely any income tax was paid on the income from a purchase life annuity.
What are the headwinds?
So, currently, what is the retirement income strategy for those householders with average pension savings? What of the headwinds? House prices may decline over the next nine years; investment returns may not sustain the required income for those nine years; annuity rates may decline.
Many economic conditions could affect house prices. One is a substantial increase in supply over demand, and affordability. Affordability can be determined by three factors – the numbers in employment, earnings and interest rates. The first two also influence interest rates.
If interest rates increase, annuity rates improve. This means the amount of money needed to secure a given amount of income reduces – the result being the amount the downsize needs to provide, or the amount that needs to be drawn under an equity release facility, does not have to be so large. This would also offset higher equity release roll-up rates that may prevail at that time.
If interest rates decline, house prices increase. This should make it easier to release a larger amount of capital to fund a higher annuity purchase price.
There appears to be little correlation between house prices and investments. The risk is that investments underperform and the retiree has to access the housing market at a bad time. If this is seen as being a risk to such a strategy, there are short-term annuities, fixed-term annuities and guaranteed unit-linked funds that could help maintain the duration of the fund.
There are many holistic solutions out there and – who knows? – purchase life annuities may make a comeback.
Bob Champion is chairman of the later life academy