With the introduction of the new pension freedoms, the key decision for many nearing retirement is between an annuity or pension drawdown. The advantage of an annuity is your longevity risk is minimised but, when compared to pension drawdown, this comes at a cost. The decision between the two should be taken as part of your overall retirement income investment strategy.
With an annuity, your retirement income is guaranteed for life. If you die soon after retirement you generally lose out but if you live into your late 80’s and beyond then an annuity is a more attractive option. However, annuity values have remained relatively low over recent years with alternative options potentially offering potentially significantly better returns.
Drawdown delivers the opportunity to make your own investment decisions to achieve higher returns and offers the opportunity to pass on whatever remains in your pension fund to children when you die. It is important to remember investment decisions must be appropriate to ensure your retirement income does not run out in retirement leaving you, and/or your partner, at the mercy of any state provision that may exist at the time.
If choosing the drawdown option it is essential to put a strategy in place to ensure your retirement income investments deliver the required returns for many years after retirement. Recent research shows that those reaching retirement age in 2030 will on average live to over 85 years of age (Male) and over 87 years (Women).
Long Term Strategy
As a starting point establishing what the best annuity package may offer gives a baseline against which to measure the drawdown option. You may wish to minimise your drawdown on your pension funds by working for longer, on either a full-time or part time basis. You may even decide to continue to pay into your pension fund (up to specified limits) while you continue to work.
Although a far from exact science you may wish to estimate how long you may live. Do you have any health problems, is your work life history likely to impact on how long you will live, what is your lifestyle, what is your family history? You may then put a basic plan in place with options should you live longer than you expect.
Income Investment Strategy
Before considering the pension drawdown option it is crucial to make a brutally honest assessment of your attitude to risk and your capability to monitor, control and make key investment decisions on a potentially significant pension fund over the long term. If you have a low-risk tolerance then drawdown should perhaps be avoided. If your investment management capabilities are limited then you may pay someone to take on this task on your behalf.
The key investment management issues to consider are:
- Regularity of income
- Capital maintenance
A retirement income investment strategy that ensures your funds are placed in a wide range potential investments minimises risk if one, or more, of those investments, should deliver lower than expected returns (or worst case crash).
Your strategy should be to maintain, as far as practical, your initial capital in the face of inflation and/or government policy while relying on capital growth to deliver an ongoing income. A key input to this strategy is therefore what your income you expect in the short and long term and the regularity of that income.
Diversification Minimises Risk
All investments carry risk. While it is impossible to eliminate the risk entirely and still maintain the income you require in retirement its impact can be reduced. With a diversified spread of investments, the impact of picking the wrong asset type, the wrong sector or the wrong region at the wrong time can be minimised.
The key issues are to set a balance that reduces risk but still provides an income. You may want to minimise risk by investing entirely in gilts but this is unlikely to deliver the minimum income you require. At the other extreme, more risky investments may deliver the income (and more) you aspire to in the short to medium term but may crash leaving you with a severely depleted retirement fund to provide an income over the remainder of your lifetime.
Regularity of income
If using drawdown to fund a retirement income it is reasonable to assume that you will require that income to be regular to cover regular bills and essential living expenses. Part of your retirement income investment strategy, therefore, should be to minimise volatility.
Any investment (or range of investments) delivering high returns, followed by significant lows may deliver a satisfactory average level of return over the long term but, if a regular income is required, this option should be avoided. Taking a regular income (drawdown) during the lows can have a major impact on the value of your fund.
It is wise to have some cash reserves (many recommend sufficient for 2 years) to avoid the need to take income from investments when at a low point. If cash is available any investments can be allowed the time to recover.
In an ideal world, you may wish to maintain the capital sum taken into drawdown and simply take a retirement income from the growth achieved on that capital. The capital is then available to draw upon should you live significantly longer than expected or to pay any care costs that may apply in later life. If any capital remains it can be then passed onto children. This may be difficult in practice but may be one of your strategic goals.
Building a retirement income investment strategy is far from straightforward and you may wish to take professional advice. The balance between risk and growth is the key, combined with the flexibility to deal with whatever life (and the markets) may throw at you.
Should you wish to discuss your drawdown options and retirement income investment strategy then please do not hesitate to call on 0800 043 8400 or Email firstname.lastname@example.org. Alternatively, complete the contact form below and we will call you at a time that is convenient.