Pensions: It’s never too late

pensions advice

Before April 2015

Back in the day, but not very far back, part of my job involved arranging annuities for members of defined contribution (DC) workplace pension schemes as they retired. Before the pension freedoms legislation was enacted in 2015, almost everyone used their pension savings to buy an annuity — a secure lifetime income — from an insurance company, after taking their 25% tax-free cash. They had no real choice. Drawdown existed but was hemmed in by restrictions except for the wealthy few; and only very small pension pots could be encashed.

People could shop around via the open market option (OMO) for the best annuity rate, and they could define their preferred annuity ‘shape’ so that it incorporated a guarantee period, escalating income, a follow-on spouse’s income, and so forth. Most add-ons diminished the annuitant’s income, initially or permanently. On the other hand, poor health increased income because life expectancy was reduced.

In any event, 75% of the annuitant’s pension savings were transferred to the annuity- provider. I was planning on starting this blog with a brief Aesop-style fable about a fox helping itself to three-quarters of a squirrel’s stashed nuts, but decided it would verge on tweeness. That’s the way it was, though, really. Looking back, it’s sobering to think that I was so accustomed to the status quo that I lost sight, on a day-to-day level, of how unfair retirees’ lack of choice was. Why should they be forced to hand over most of the money they’d saved over many years? I remember one of my colleagues saying a while ago that the expression he hated most in the English language was: It is what it is. This casual remark stayed with me because he had such a valid point. Very often there are other ways, or there should be, but routine creates tunnel vision. It is what it is — until it isn’t.

As retirement approached then

It’s a truism to say that your pension gets more interesting as you get older. Time and again, people in their late 50s and early 60s would ask me this question: Should I increase my pension contributions during the final few years of my working life?

Answering wasn’t straightforward. Yes, increasing your contributions would increase the income tax boost you gained, and yes, you’d be able to get 25% of the final value of your pension back free of tax. But your money would only have a short time to grow (potentially) in value, which is riskier than investing for longer — and you’d have to use 75% of the proceeds to buy an annuity. Do you want to relinquish spare cash at this late stage? Have you thought about contributing to a cash ISA or an equity ISA instead?

Another inequitable system in place then, incidentally, was that advisers earned commission on the asset value of workplace pensions and, often, on the value of contributions too. This could create a conflict between doing the right thing for clients and doing the profitable thing. Unscrupulous advisers will always find ways to rig the game, but at least commission of this type has now been abolished.

As retirement approaches now

Up-to-date stats are hard to find, but the trend is clear enough. The number of people buying an annuity has declined dramatically and withdrawing money flexibly has become the norm.

So, nowadays, when people approaching retirement with the intention of taking income flexibly ask the same question about whether they should increase their pension contributions, my answer after discussion is nearly always: Yes — go for it.

The pension freedoms have removed constraints, so there is a key difference now. Money invested in a pension not long before retirement won’t be so vulnerable to short-term market fluctuations because it will have many years in which to grow (again, I must add, potentially). According to the ONS, in 2016 the average man aged 65 in the UK would live for another 18.5 years, and the average woman for another 20.9 years. Flexi-access drawdown (FAD) providers have put together post-retirement default funds so that people don’t have to make their own investment decisions if they don’t want to.

They can assume that the more they contribute before they retire, no matter how close retirement is, the better off they’ll be. Moreover, if you are unfortunate enough to die soon after you retire, your nominated beneficiaries will inherit the money in your FAD account, free of tax in most circumstances.

Is there still a place for annuities?

Yes, indeed there is. For some, using their residual pension value in its entirety to buy an annuity represents security and certainty, which will be the right choice for them.

Other people might decide to go into FAD for a few years, then use their remaining money to buy an annuity, when rates will be higher because life expectancy will be lower. If there has been a decline in health, this will also enhance the rates available.

And then there is the option of converting some pension savings to an annuity at retirement and putting the rest into a FAD account, with the aim of getting the best of both worlds: a secure baseline income topped up with taking extra money as and when it’s needed.

Anyone buying an annuity should take advantage of the open market option (OMO) and obtain quotes from multiple providers. Rates across the market can differ significantly, especially if ill health is a consideration.

Choice confers responsibilities

Life is less fair but simpler without choice. The previous annuity-only route was clear: for this much capital you get this income for life. Which leads to my two main misgivings about FAD.

One is that people may not budget properly. They’ll underestimate their longevity and overspend in early retirement, so that their savings run low or run out in later retirement.

The second is that most people have very little understanding of how investments work and so could make poor decisions. They may be nervous of taking any risk and keep their money as cash in a FAD account. Its value will then be eroded by inflation. This situation was memorably characterised by the coalition government pensions minister Steve Webb as ‘reckless caution’.

We hope digitisation and the apps now being launched by pensions providers will change behaviour, but beyond glancing at their annual statement most people don’t currently monitor the value of their pension when they’re saving for retirement until it’s only a few years away. After they retire it seems likely they’ll keep a closer eye on things. Generally, markets have risen since the 2008/09 crash. A severe market downturn in the future may come as a shock to inexperienced investors, causing them to panic and switch from growth assets to cash near the bottom of the curve, before the market recovers. This would be an expensive error.

Financial education is essential

I believe that employers have a duty to provide pre-retirement education to older employees. If people, when they are still earning and squirrelling money away for the future, aren’t given the opportunity to learn about the choices facing them when they are no longer earning, they are ill-equipped to enjoy a comfortable retirement.

Employees, if their assets are at all substantial, should also consider taking formal financial advice as they reach retirement. Paying a one-off fee for advice could save them a great deal of money in the long run.

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