Forget Anno Domini and Before Christ – pension investors now have their own definition of year zero. Following this monumental year for retirement saving, investment strategies can henceforth be characterised as either BPF or APF: Before Pensions Freedom or After Pensions Freedom.
It may be stretching the analogy a little to liken George Osborne to a prophet, but the Chancellor gave scheme members and providers 13 months to prepare for the event that has transformed the way Britons save for and spend in retirement.
Before the Budget of March 2014, in which Osborne announced he was scrapping compulsory annuity purchase and treating pensioners “like adults”, 92 per cent of defined contribution savers typically bought an annuity at retirement. In April 2015 the Chancellor’s plans came to fruition and, in the two months during which pensioners have been able to access their retirement savings, around 60,000 over-55s have withdrawn a total of £1bn from pension funds.
Osborne says these figures prove that his changes have been a success and he urges pension providers to “up their game in helping customers to make use of these freedoms”.
These early adopters of the new pension rules are those with smaller pots, averaging just £16,600. Not having to purchase an annuity with such sums makes sense – according to Prudential, a pot of this size would result in an annual income of around £500.
But what of the larger pension pots? According to stockbroker Hargreaves Lansdown, just 8.4 per cent of eligible investors on its fund platform are choosing to buy an annuity, while 75 per cent have opted for drawdown and 16.6 per cent have withdrawn a lump sum.
Hargreaves head of pensions research Tom McPhail thinks transactions have not settled into a normal pattern.
“The current high levels of drawdown and lump sum transactions are likely to still be the pent-up demand held over from 2014/15,” he says.
“We see evidence that demand for annuities may grow again over time as investors are looking for higher levels of secure income than flexible withdrawals.
“We’re also interested to see that death benefits are now being cited as a reason not to withdraw money from a pension.”
In May 2013, a report commissioned by the Financial Conduct Authority (FCA) found that, as DC pension schemes took a greater proportion of market share from defined benefit schemes, annuities would become more important to consumers.
“While it seems very likely that the number of annuity sales will increase in coming years, the pipeline is difficult to predict with any certainty due to changing consumer behaviour in the annuity market, changes in economic activity among older people and changes to pension policy,” the report concluded.
Loss of appeal
But despite this, since the global recession of 2008, annuities have been considered unattractive to retirees. Those retiring in the aftermath of the crisis had to deal with the double whammy of a stockmarket slump causing their capital to fall in value and declining 15-year gilt yields, meaning annuity prices have been dismal.
People retiring in July 2007 could buy an annuity based on a gilt yield of 5.28 per cent; by February 2015, this had fallen to a paltry 1.93 per cent. So even the staunchest of annuity fans can understand why they have lost appeal.
Add to this that at least half of annuity buyers do not maximise their income potential by exercising their open-market option and the problem is compounded.
In a 2013 paper entitled ‘Estimating the True Cost of Retirement’, Morningstar Investment Management head of retirement research David Blanchett suggests that, while a replacement rate of between 70 per cent and 80 per cent may be a reasonable starting point for many households, when actual spending patterns are modelled on a couple’s life expectancy rather than on a fixed 30-year period, many retirees may need around 20 per cent less in savings than the common assumptions indicate.
According to a survey compiled by The Guardian newspaper in the UK, peak earnings are typically achieved between the ages of 40 and 49. For those aged 50 to 59, the average weekly wage is £536, making an average salary of £27,872. Based on Morningstar’s estimate that retirees require 70 per cent of their former salary, this means that pensioners are targeting an annual income of around £19,500.
Current best buy annuity rates for a single life level annuity are around 5.8 per cent – meaning one needs a pension pot of £336,000. Those retirees with minor illnesses or who smoke may be able to secure an annuity rate of 6.5 per cent and will only need £300,000 to hit a retirement income of £19,500.
“Income drawdown can be complex,” warns JP Morgan Asset Management head of UK defined contribution Simon Chinnery.
“Grappling with investment risk in retirement, most notably the risk of running out of money before you die, can be a challenging uncertainty. These freedoms have opened up an opportunity for financial advisers to guide people through this new retirement landscape.”
A common yardstick for drawdown is to assume a withdrawal rate of 4 per cent a year – from a combination of capital, investment yield and, hopefully, some capital growth. This means the average pensioner aiming for the £19,500 target would require a retirement pot of £487,000, according to calculations by Hargreaves Lansdown.
Investors who are unwilling or unable to draw income from capital could target a retirement income purely from yield.
The FTSE 100 is currently yielding around 3.5 per cent; a comparable pension portfolio with a similar yield would require an investment pot of £557,000 to pay out £19,500. A more conservative portfolio with a higher allocation to bonds may yield 3 per cent and require an initial sum of £650,000 – considerably more than the average pension pot of around £40,000.
Drawdown obviously offers greater flexibility than annuities; one can choose to take more or less in any given year, or indeed withdraw the entire capital in one lump sum, subject to tax. However, any income is a target, not a promise. Much like simple structured products, investment portfolios are designed with an income target to deliver but there is no guarantee that the capital will not be affected – nor that the income will be paid.
Even the FCA recognises the dangers of drawdown, stating that “a drawdown pension, using income withdrawal or using short-term annuities, is complex and is not suitable for everyone”.
One look at the performance of the FTSE 100 over the past decade will serve as a reminder of how difficult it is to smooth investment performance. Even multi-asset strategies were hit in 2008.
Annuities are the only product that guarantees to deliver a pre-determined level of income for life, but with the equal promise that you will never see your capital again.
As neither approach is perfect, Nest chief investment officer Mark Fawcett says investors need to stop thinking in terms of annuities or drawdown and take a blended approach.
“We think the old binary debate between annuities and drawdown is less relevant since the freedom and choice reforms, particularly for the auto-enrolled generation,” he says. “Our research suggests these savers will want something more flexible, which combines elements of both.”
It is a view also held by Morningstar. Influenced by his experience in the Australian and US retirement markets, Morningstar global chief investment officer Daniel Needham says everyone has unique needs and preferences and one size rarely fits all.
“In a well-balanced retirement portfolio, lifetime annuities and lifetime guaranteed income products can play a role – just not the only role,” he says.
“Combining guaranteed products and traditional assets into long-term retirement portfolios can allow individuals to balance the need for lifetime inflation protected income and the ability to access one’s savings for unexpected changes in people’s circumstances.”
Punter Southall Group principal Rob Tinsley says the concept of blended solutions is a good starting point for most people. An analysis of expenditure is split by the basic cost of living followed by lifestyle choice spending. Finally, legacy enables the individual to split their DC fund between cash, annuity and drawdown.
Tinsley calls this the “three buckets” approach.
“The first is the guaranteed bucket filled with state benefits, any DB and perhaps some DC, through annuity purchase, so that the basic cost of living is covered,” he says.
“This provides the foundation to then use flexibility within a drawdown-type arrangement to provide for life choices and ad hoc cash expenditure. Depending on the size of DC pot and other assets held, there may also be scope for an individual to use this for legacy purposes.”