IFA guide to options at retirement
Managing finances in retirement requires advice in a number of related areas including pensions, investing your private capital, tax planning, provision for medical and long term care costs, as well as estate planning.
It is prudent to take a holistic view of your retirement finances. However, this is easier said than done because few clients have the time or necessary skills to do this. In any case, it is only human nature to deal with today’s issues and leave financial planning to tomorrow, which never comes.
It is important to recognise the necessity for holistic retirement planning, but at the same time to acknowledge that there is a balance to be struck between the desire for relatively straightforward solutions and the more complex solutions which provide more flexibility and control
Experience has shown that for many people retirement planning is a process of transition from their working life into their retirement lifestyle. Many people, when they first retire, want to retain as much flexibility and control as possible and take an active involvement in the process. But as they grow older, their priorities change and they may wish to gradually relinquish flexibility and control in favour of peace of mind and security.
No matter whether you are considering a relatively straightforward drawdown plan or a more complicated retirement plan, you should start by setting out your objectives, and then considering which plan or combination of plans helps you best meet your objectives.
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Setting your objectives
It sounds easy enough to define your financial objectives in retirement, but in practice many people find it difficult to set out their objectives clearly because there is often more than one objective and some of these may conflict with each other.
There are four principle retirement planning objectives. Providing for an adequate income, flexibility to meet changing circumstances, minimising tax and family protection.
Income requirements
Generally speaking, people fall into three camps. Those who want the highest possible income, those who seek a sustainable income with protection against inflation and those who want to minimise their income.
In the context of taking an ‘unsecured pension,’ there is a real danger that those looking to take the maximum income will see their future income reduce, if investment returns are not sufficient to cover income withdrawals. If the objective really is to get as much income as possible, then it is worth considering annuities, as those who see drawdown as a way of getting a higher income than from an annuity, may end up very disappointed.
The term ‘sustainable income’ refers to an income that is protected against the effects of inflation and will last for life. The benchmark for this should be an inflation proofed annuity, as this is the only financial product which can guarantee a sustainable income. One of the challenges for drawdown is whether it can provide at least the same income as an index-linked annuity, but without undue risk.
Taking the minimum income from a drawdown plan may seem to be the lowest risk option, but there is an opportunity cost and the danger of diminishing returns. The opportunity cost is that, if you had extra income now you would have the opportunity to spend or invest it.
However, if you defer taking the income you give up this opportunity now, in the expectation that you will have a higher income in the future. If, though, your future income is not higher, then you will have sacrificed income for no benefit.
Flexibility to meet changing circumstances
One of the valid criticisms of annuities is that they do not allow for any flexibility and many people who have just retired want to have flexibility, in case their circumstances change in some way.
Drawdown provides income flexibility because income can be varied between the minimum and maximum limits, there is control over the investment strategy and flexibility over the death benefits on death before age 75. However everything has a cost. The cost of flexibility must be seen in terms of additional cost and risk, including the risk of a lower income compared with purchasing an annuity.
It also worth considering if you will still want to be exposed to the same amount of investment risk at an older age. Your attitude to risk may be quite different at age 70 compared to that at age 60 or 65.
Minimising tax
A much talked about, but little used, feature of drawdown is the ability to minimise tax by managing the level of income. This can be particularly useful if it is advantageous to reduce income in any one year to help offset income from other sources.
For those who are serious about minimising tax, especially higher rate taxpayers, phased retirement should be considered.
Family protection
It is only natural to want to ensure that on your death your spouse and family are financially secure. The most obvious criticism of an annuity is that on death there are no remaining funds to leave your family when you die and so drawdown looks attractive because it allows for a lump sum payment on death before age 75, albeit with a 35 per cent tax charge.
Unfortunately, the logic is not as sound as it might seem. First of all, the problem for many people is not that they will die young, but many will live to a very old age. An annuity insures against longevity, but there is no such protection with drawdown.
The dilemma for many is that if you die before age 75, the death benefits under drawdown may be more than if you had bought an annuity, but if you live beyond 75, the death benefits will only be higher if the final annuity is higher than could have been bought at the outset.
Secondly, from a practical point of view, it might be more desirable to provide a surviving spouse with a guaranteed income stream, rather than a lump sum, which attracts 35 per cent tax. It is worth remembering that pensions are designed to provide income, not to provide lump sum death benefits and it may be more advantageous to look to maximise income from your pension and to do your estate planning with your other assets.
Alternatives to drawdown and annuities
It is not possible to meet all your objectives at the same time, as some of them will contradict each other. For instance, you want to maximise your lifetime income, but at the same time maximise your death benefits. These objectives are incompatible because only an annuity can achieve the former, and drawdown the latter.
Maximising income may mean sacrificing death benefits, and maximising death benefits may result in sacrificing income. But since pension simplification came into force in April 2006, financial providers have had the freedom to create more flexible retirement solutions, which is why there are now a number of so called ‘hybrid’ products which provide a third option to annuities and drawdown.
Hartford Guaranteed Retirement Income Plan (GRIP)
Hartford Life claims to be the first provider in the UK market to have successfully bridged the gap between conventional drawdown plans and annuities, with a product which pays out a minimum guaranteed retirement income for life.
GRIP, which is effectively a drawdown plan offering a fixed income for life, allows you to lock in up to 10 per cent of any increase in your fund value each year up to age 75, at a cost of 0.35 per cent AMC. The downside is that you will not benefit from any fund increases in excess of 10 per cent.
You can also draw a minimum income for life from age 55 of between 4 per cent and 6 per cent of your guaranteed retirement income plan. This costs 0.75 per cent AMC, which is based on the original amount invested, plus any additional contributions.
The maximum age for entry is 70 and the minimum initial contribution or transfer amount is £10,000. Other guaranteed drawdown products, including Metlife’s Trustee Investment Plan and AIG’s Living Time product (see below), can lock in returns, but clients must buy an annuity or an ASP at age 75.
So GRIP provides two main benefits:
- a guaranteed income for life
- a guaranteed death benefit
The guaranteed income for life option allows investors to secure, and ‘lock in’ to a guaranteed pension income. By so doing, GRIP protects the future level of income from falling, if the value of the underlying investments falls. GRIP allows you to secure, and ‘lock in’ the value of death benefits. As this is a drawdown plan, a lump sum less 35 per cent tax can be paid if you die before age 75.
As with all such investments, there is no free lunch. There is a price to pay to for the income guarantee and this is represented by the increased fund management charge of 0.35 per cent per annum, increasing to 0.75 per cent, when income drawdown starts.
The income guarantee is simple to understand but complex for Hartford to provide. The simple bit is that an investor aged 60 can take an income of 5 per cent of the value of the fund on day one. At the end of the year, if the fund has grown (after income withdrawals), the guaranteed income will increase to 5 per cent of the new fund value (subject to a maximum 10 per cent increase).
The income guarantee is for life, even though this is a drawdown plan. Under current rules, drawdown ends at age 75 and Alternatively Secured Pension kicks in. However the investment ‘lock in’ stops at age 75. There is also an option to purchase a secured income (annuity).
GRIP and other guaranteed drawdown plans, that have been modelled on the variable annuity plans that are popular in the US, serve a useful purpose as a ‘half way house’ between a conventional drawdown plan and an annuity.
They provide the more sophisticated investor with an opportunity to secure a guaranteed income, while at the same time having flexibility and control over their investments. For other alternatives to straightforward drawdown and annuities, such as:
- Aegon’s 5 for Life;
- Living Time;
- Prudential’s Flexible Annuity
read our consumer guide to “Your options a retirement” at http://www.find.co.uk/pensions/personal_pensions/your_options_at_retirement
Conclusion
Income drawdown has been described as one of the most complicated aspects of financial planning and that is no exaggeration. In order to ensure that you are making the correct decisions, you should work out the process of identifying your objectives and risk profile, understand the options and implement an appropriate investment strategy.
Get it right and you will benefit from the flexibility and control over your pension income. Get it wrong and you will wish that you had bought an annuity in the first place.
Last edited March 2007
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