Dispatches: How to Blow Your Pension
Last night Channel 4 showed a 30 minute programme called “How to Blow Your Pension”. The premise being that the new pension rules might result in thousands of “pensioners” cashing in their pension pots, blowing the lot only to run out of money. You can see the show on the 4OD website should you wish to. The intention was good, but the execution rather miserable and once again missing the opportunity to educate people and whilst Michael Buerk had a good reputation as a BBC newsreader, clearly he doesn’t appreciate that a document from a pension provider is not actually advice – but information about options. Frankly it isn’t that much of a jungle out there, but you will need proper advice, this is not the time to become a DIY internet “expert” it has to work and last. Just because someone has teeth that they care for, doesn’t mean that they should do their own dentistry. Just because you earn, handle and spend money does not make you best placed to do a proper job of planning and generating income for the rest of your life… So I thought I’d have a go at explaining the issues.
New Pension Rules – Simple
Pension rules are changing, from April 6th 2015 anyone aged 55 will be able to access their entire investment based pension pot should they wish to. There will be no compulsion to buy an annuity (an income for life). The principles have not changed – in that 25% of the pot is treated as tax free and the remainder is treated as income when you take it, however you take it – and so subject to income tax at your relevant rate of tax. You can still buy annuities should you want to. That’s it.
Running out of Money
The difficulty is that for most people their pension needs to last as long as they do…. ideally a bit longer if they have a spouse that outlives them too. So in practice you need to be careful about how much you take, its got to last and once its gone, its gone. So you have to guess how long you and your spouse might live (clue – actuaries do this for a living and designed annuities).
Make a Plan
So you will also need to reflect on how much income you need, what plans you have and it would be sensible to allow for some unexpected costs. You may need to pay for your own care or medical treatment – if you wish to choose how this is provided to you. You will also need to reflect on the impact of inflation, which at the moment is at record lows – but do the things you pay for really have such a low rate of inflation? and making a guess now for the next 20, 30 or perhpas 40 years of retirement needs some proper thought. If you don’t buy an annuity (which for many will be a very sensible option) the fund will need to grow (just to stand still and keep pace with inflation at the very least) – so how much investment risk is appropriate? what returns do you really need? what happens if these aren’t achieved? how will the portfolio be looked after? … and so on.
Review the Plan
As a result of these new “freedoms” (which some already enjoy anyway) you have a plethora of choices and the truth is that these need to be reviewed – in fact thats the beauty of it all, you get to alter your decisions (unlike simply buying an annuity and having to live with the consequences for the remainder of your life). The ability to access the money means that the crooks are on the scent… be it “pension liberation” or rubbishy investments that aren’t regulated and promise more than they could ever deliver. An independent financial adviser can sort the wheat from the chaff, but a financial planner, will do that and also help you plan your income requirements to suit your unique requirements.
Was that really so hard?
An annuity is an income paid for life. Simple. Generally people buy an annuity with a pension fund, which for the vast majority of people is when they retire. The rules changed recently with George Osbourne’s Budget in the Spring, this meant that from 6th April 2015 nobody has to buy an annuity if they dont want to.
This is an acutaries field day, but let’s keep things simple. Annuity rates are closely linked to interest rates, investment returns and life expectantcy. Over the last 20 years interest rates have fallen considerably (as anyone can observe) so too has inflation and with that investment returns, though “real” (after inflation) returns have been fairly constant over the long term. People are also living longer (on average) – meaning that any income needs to be paid for longer. So actuaries do their sums and review their sums based on these factors.
As a result annuities have fallen from double-digit rates in the 1980’s and early 1990’s to very low and comparativley measly figures today. As a result people understandably look at the size of their pension pot and the projected annuity income and don’t like what they see. Hence pressure over the years to abolish the requirement to have an annuity, which is essentially a decision made once at 65 that cannot be altered and one you have to live with for life.
The current regulator (my fifth!) has recently published its findings about annuities and how they have been sold. Most of the report is nothing new, myself and other advisers have been calling for change for years. The main problem being that the vast majority of people do not think to consider the options at retirement properly. Far fewer still do any proper planning (working out how much income is needed, when and for how long etc). Most assume, rather strangley, that their existing pension company is simply offering them the “best deal” which is rarely the case… I’m reluctant to say “never the case” but I am tempted to do so. This is why people need to “shop around” but more sensible still – engage a financial planner to properly assess and explain your options. There can be enormous differences from simply getting a better deal, let alone the most suitable, which takes account of your needs, tax and so on.
Whilst the press have been covering Mr Osbourne’s pension freedoms, annuities certainly still have a place and are one of a number of “tools” to consider. For starters, of all the options, they are the only ones to provide guarantees. So if you know anyone that is in the process of retiring don’t let them get confused by the media noise, but encourage them to seek advice from a financial planner – like me.
Pension, annuities, the Budget and life’s big gamble
I’m well aware that we in financial services often seem to live and breathe pensions, savings, investments and tax… and for most people this is a necessity not an interest. This week my peers and I have been quite taken aback by the changes to pensions, annuities and ISAs. Assuming the proposals are approved, this means significant improvements for clients, but not without risks.
So What?… meet Mr & Mrs Cash from Wimbledon
Let’s suppose a healthy, non-smoking married couple Mr & Mrs Cash are both 65 years old, and live in the leafy suburbs of south west London in Wimbledon (SW19). They want an income of £30,000 a year and would like this to rise by 3% a year to keep pace with inflation. They want this income, even if one of them dies, continuing at the same rate until finally both have left this mortal realm.
Annuities are so poor at present that £100,000 buys only £3,359.04 a year, so as the Cash’s need £30,000 a year initially, they would need a pension pot of £892,857 to provide this, excluding any requirement for tax free cash. Now that you have picked yourself up off of the floor…a joint life 100% spouse’s annuity with a rising income today has a best annuity rate of 3.36% (and by today, I mean I got this quote online today).
So now the “interesting” part, which is where the educated guesswork begins and the gamble with life really gets exposed. Remember that the annuity I have shown will last for the lifetime of the couple, income will be £30,000 a year and keep pace with inflation (provided inflation is 3% or less). Once the couple die the annuity stops, there is nothing left.
The alternative for this couple, with a fund of £892,857 wanting £30,000 a year increasing by 3% a year is to convert their pension into a flexible Drawdown pension, keeping the money invested. Let’s suppose the investment grows at 6% a year on average (3% above inflation). It NEVER runs out. In fact by the time they are 100 the fund is worth £1.9m having had a total income of £1.8m out over 35 years (by the way their income in that year… 35 years from now is £81,957… which in real terms is £30,000 today. Yes the investment will fluctuate in value, but we are, in this instance only wanting a modest income from it each year.
Its all in the gene’s..
Ok, so back to life’s big gamble…. How long will Mr & Mrs Cash live? The average UK female aged 65 will live another 20.62 years which is longer than the average male who has 18 more years according to the ONS figures. Let’s assume this is a couple that due to diet, lifestyle and good genetics live longer – to 90 (that’s 25 years). To do this they would need £512,153 in a portfolio, which grows at 6% a year. This would then run out at 90. Nothing left, nada, gone, zilch.
My point being that a much smaller pension pot is required (with these assumptions) its about 58% of the fund you would need to do the “same thing” when buying an annuity. I say “same thing” as of course if the couple live beyond 90 the annuity continues to pay out, the pension has all gone.
Not living long enough
Equally if both of them die “prematurely” at say 78, then the annuity finishes, there is nothing left. If the money is in the pension, there is a balance which can be passed to beneficiaries. Today this would suffer a 55% tax charge, but if I’ve understood the proposals, this will reduce to income tax rate levels. This is still to be clarified, but either way there would be money left in the pension (£1.2m by my maths). Let me say that again… there is £1.2m (one point two million) left rather than nothing.
The advantage an annuity provides is that it is guaranteed for life, so you know what you are getting. This can be a very good thing in the right circumstances. But it’s a one time decision and if you don’t live long, one might suggest that it was terrible value for money, it is only in year 22 that the total income that you would have had over 21 and a bit years would surpass your original capital investment… making one or both of you 87 essentially before you’ve “had your money back”. This is all down to low annuity rates, which are due to interest rates, inflation, economics and life expectancy… things that you and I can influence very little.
Should we trust people with their own money?
Of course the danger of access to a pension is now being discussed in the media, there is justifiable concern that people may simply take their fund and blow it all at once…. on a nice car? Remember that this is taxable income, so any amount over £150,000 would be taxed at 45% and once its gone its definitely gone with no further help from the Government. There are concerns, and yes some people will blow it. However, from next Thursday, this feature is only available if you have £12,000 a year in guaranteed income (in your own name) currently you need £20,000. This amount does include your State pension and any other employers pension. So a lot of people will qualify, but of course not all by any means. Those with small pensions will not be able to use this feature, but they can use “capped drawdown” instead, which has also been improved, but clearly those with smaller pensions probably need more certainty for their own budgeting.
So where is the catch? well, between you and me….. I imagine that the cost of residential care will now be raiding many people’s pension pot in a rather more aggressive fashion, so spouse’s be warned… have your own pension pot.
Of course there are many more options and you could always decide to use the fund to buy an annuity at a later date (annuity rates tend to improve with age) and careful maths needs to be done and dreaded terms like “critical yield” may become a familiar term to many pensioners in the future. This is why reviewing your financial planning regularly (annually) with a us is really important and of course we can demonstrate the options and their consequences. So get in touch.
As we have discovered, a pension, at least in the way the financial services industry use the term is a savings plan. Its has two main advantaged over other forms of savings plans. The first is that an employer or business can pay into the savings plan for you. The other a more obvious is that contributions attract tax relief. These are both massive advantages and could be described as “money for nothing”. Under the new auto enrolment rules your 4% payment to a pension is essentially doubled, with 3% from your employer an 1% from HMRC. However be aware that as with all things, today’s rules are no predictors of the future, one that I may remind you is shaped by economic realities and the politicians that attempt to pretend otherwise.
So what are the alternatives? Well they are almost infinite, but lets narrow this down to three simple ideas.
- A Business
As a pension is simply a pot of money to take income from for the rest of your life (with the option of buying an annuity if you want to). Then any form of investment can do this job, including a bank account (if indeed we can call holding a cash deposit account an “investment”). Today I will only focus on the investment option.
An Investment Portfolio
Investing is fraught with possible mistakes, almost every investment promises “out-performance”. This is largely hot air. Apart from selecting suitable investments and constructing a portfolio, investing has costs and any income from an investment, for example a dividend payment is liable to tax. Gains are also subject to capital gains tax. There are “tax free” investment products such as ISAs, but for many people the amount that can be put each year into an ISA is unlikely to be enough for your retirement (though many will find it more than they can actually save).
Are investments more risky than a pension?
No, you could have identical holdings in a pension and a “regular” portfolio. The issue is understanding how the portfolio is constructed, why and what returns over the long-term are likely to be achieved. Anyone that promises guaranteed results is being less than honest with you. Everyone has a different idea about which assets or markets will perform best – that’s kind of the point of a market – where people agree a price on something when they disagree what direction that price is heading. Its true that there are other tax efficient ways to invest, using EIS, VCTs and such like, but be warned, the term venture or enterprise is used sensibly and most people are neither.
So let’s take an example and agree lots of assumptions
Suppose you need an income of £20,000 a year and inflation-linked at 3% a year (yes we are guessing). If you only expect to live 10 years from retirement at 65 and are happy with this assumption (that the money runs out, all gone, nothing left!) then the income (actual cash) you take will be nearly £230,000 over 10 years to age 75. If we assume that the portfolio grows at 5% a year during this time (which may be ambitious as you are probably keen to have certainty that the money will pay out for 10 years) then you need a fund of about £175,000 at 65. If you expect to live for 20 years and then the fund runs dry… well you would take out total income of nearly £540,000 and need a pot of £320,000 at 65 to provide this.
What would an annuity give me?
If you were to buy an inflation linked annuity at 3%pa as a 65 year old, you would probably need about £500,000 at 65. This is based on a 4% annuity rate (4% of £500,000 being £20,000pa) The advantage of the pension route is that if you live longer than 20 years (85) it continues to pay a rising income until you die. The investment pot has run out. Both have the same assumptions about inflation (which will be wrong in practice, unless you are going to credit me with mystic powers).
Pension or ISA?
So here’s the hard numbers. The pension pot needs to reach £500,000 and the ISA investment portfolio, well let’s go for £320,000 and assume we can predict death at 85. Lets suppose we start saving at 35, giving us 30 years to grow the money by the time we are 65. Let’s also assume the pension and investment portfolio hold the same stuff and perform identically, with the same charges, let’s assume that over 30 years the funds grow at 7% for the sake of simplicity. We will also assume that you increase what you save by inflation (3%) each year so that the amount you pay is proportionally the same each month. This is now virtually a GCSE maths question (if only they’d taught us the maths that was important in life right!).
So to build £320,000 in the ISA investment portfolio, you need to invest £195.64 a month rising by 3% a year, a total outlay of £113,220 over 30 years. As you may imagine to achieve £500,000 in the pension over the same time with the same returns, you need to invest £305.69 a month initially, increasing by 3% a year. A total outlay of £176,906 over 30 years. So the pension costs you £63,686 more (about 36% more). However, with the pension you had 20% tax relief, so you really paid 80% of £176,906 or £141,524, still more than the ISA, but not that much more.
- £500,000 Pension pot actual cost for basic rate taxpayer £141,524
- £320,000 ISA pot actual cost for basic or higher rate taxpayer £113,220
Your employer can make payments too
Now imagine that your employer was also paying into your pension pot (which they cannot do with an ISA). Suppose that they are paying 3% of your salary – as they will be under auto enrolment, let’s assume you want £20,000 a year because you reckon that’s what you need to support your equivalent lifestyle today, so let’s just assume you earn £30,000 at the moment, so 3% is £75 a month. So if your salary rises at 3% a year in the same way, over 30 years, that’s £43,404 of employer payments in total. You can therefore reduce your own payments from £305.69 a month by £75 to £230.69 a month, which in practice is £184.55 a month net of basic rate tax relief…. Which is marginally less than the £195.64 you need to save into an ISA.
- £500,000 Pension pot with 3% employer contribution £106,804 net of 20% tax relief
- £320,000 ISA pot £113,220
Of course the more your employer pays the better, but I hope that I have demonstrated that tax relief and employer contributions make a big difference. Don’t forget that the annuity dies with you (unless you build in benefits for your spouse) but anything left in the ISA portfolio is merely added to your estate and subject to inheritance tax. The big gamble is predicting your life expectancy.
Tomorrow I turn to property as an investment. I hope that it evident that this is not advice, I am merely outlining an example and doing the sums. You should get specific advice to suit your circumstances.
Dominic Thomas: Solomons IFA
Money Box asks: has your pension been burgled?
Once again pensions were in the news, the Radio 4 show Money Box took on the rather complex issue of annuities. Charges, fees, value for money Financial Services Consumer Pension and even the very funny Jeremy Hardy’s comments on The News Quiz also received some mild stick, following his joke about not wanting to understand anything about annuities, or listen to Money Box and his intention to be a burden to the State..of course he was being ironic.
Anyhow, Jeremy is pretty much right, annuities are very boring and not something to spend too much time worrying about… until you actually need to. So what is an annuity? Ok simple stuff… an annuity is an income for life. You can have a rising income or a level income. Importantly an annuity dies with you.. eh? When you die your annuity stops… but if you want you can build in some guarantees… such as the income continues to pay a spouse or your estate, in full or part.. you can build this in at the design stage, not later on.
So why are Money Box and the FSCP talking about annuities?
Well, most people have no idea what to do and most is a lot – something like 400,000 people retire and buy a annuity each year. It’s a large market. Most people assume that there is not much between annuities (sadly and expensively wrong) there is an enormous difference and it costs you no more to get the most suitable one (on the whole). I’ve not met anyone that likes a pay cut, particularly one of 20% or even 40%… yet that is precisely what the wrong annuity is effectively like….for life!
So can I shop around for a better annuity?
Yes, you should (no you MUST). Start by checking out the MAS site, the site that supposedly advisers dislike, yet pay for via our fees… and plug in some details. If you like to be frightened, do this now. This is only part of the story and did you notice all the disclaimers? You could then approach the annuity providers yourself and set up your annuity. You won’t get any more money than if you did this via an adviser, but the provider makes a bit more money out of you, and you carry the risk for picking your own.
So should I use an annuity broker?
Well you could, but be warned that they may simply focus on getting you the biggest annuity (which seems ok doesn’t it?). If the company provide guidance rather than advice, they are not liable for any mistake, you are. They will charge a fee for their selection. However, this might be akin to going to a garage with a car that has a flat tyre and won’t move… demanding a tyre at a decent price… but failing to observe that the car has no engine (ok it’s a metaphor). My point being that there is no context for good planning, it’s just selling or arranging products, as Paul Lewis reminded the listeners.
So should I pay for financial advice about annuities or retiring?
Well, I would say this wouldn’t I, but of course! There are lots of issues and lots of solutions. My main gripe with annuities is simply that once you set one up, that’s it, decision made for life. A bit of a straight-jacket if you ask me. More importantly perhaps the adviser is qualified and responsible for the advice.
So what will a good financial planner do?
Start by forgetting about products. Discuss your plans for your retirement and determine what that really means for you. In short, what lifestyle are you aiming for? How much will it cost? So this is about income, not products. The sort of things that need thinking about and understanding are your requirement for income, your tax position, your other assets, your marital status, your expectations about inflation, your health and how long you will live. Advisers need to help work through the tricky discussion about the risks of not knowing. There are alternatives (lots) and of course there is the option of not even buying an annuity at all. Good financial planning is not about products it’s about figuring out what you really need and then building a plan to get you there.
Do financial planners have to arrange products?
No, but we often do. I really wish that Money Box would grasp this point. A good financial planner may not ever arrange products at all (I have a dream)…frankly because arranging products is a pain and very, very dull. Solving problems and helping people to get the life they want… well that’s an entirely different matter…however if you want a job done properly…
Anyway, keep up the good work Money Box… time often seems against any proper full discussion on the main media channels, so I am currently toying with my own show…well a podcast anyhow.
Dominic Thomas: Solomons IFA
So what’s the fuss about annuities?
You may have come across yet more media coverage in relation to rip-off financial services. The story, like most has some truth to it, but some… well let’s just call a spade a spade…inflammatory errors. Here I shall attempt to briefly convey what the fuss is about in relation to annuities.
What is an annuity?
First off, what is an annuity? In short, its an income paid for life, most of the time paid like income (and taxable) every month. You can choose for it to stay the same (level) or rise each year (to keep pace with inflation). You effectively buy an annuity with your pension fund.
Are you getting a bad annuity deal?
Easy enough so far… so what’s the fuss about? In short, most people don’t shop around for the best deal in the belief that they wouldn’t get much more, or simply didn’t know they could. As a result many or most buy their annuity from the company their pension is with. In most instances they aren’t getting the best deal or anything like it.
The main problem with buying an annuity is that you make your decision and have to stick with it for the rest of your life. It’s a one time deal. So any decent adviser will help you to think about the income you want well in advance of the day you decide. A financial planner will do this from the start (not just before you retire). So good planning is planning ahead and figuring out how best to tale your income and when, pensions and annuities are simply part of the picture, not the entire story.
There’s not much between them right?… wrong!
Is there really much difference? Yes. There is a massive difference. This will depend on how old you are, where you live, your life expectancy and your state of health. Bizarrely, the worse your health the better the annuity (as the annuity company won’t expect to pay it out for as long as someone with good health). Getting this part right alone could increase the income by 20%-50%. The message here is to shop around… however the reality is that this isn’t the whole truth, you really ought to use an IFA to do the shopping and set something up having discussed all of the options properly… in-line with your requirements and expectations about the future.
Planning ahead, understanding the bells and whistles
The bells and whistles… when you die the annuity stops. However you can have it pay in full or part to your spouse or your estate, you can put in guarantees. You can mix and match. You can delay. There are lots of things to think about and an IFA will do this, for a fee. This is money well spent and ultimately, if things go wrong the IFA is responsible for the advice (unlike a journalist or doing it yourself). The really important thing is to be engaged in the process and thinking about what you want your lifestyle to be in the future, when you do eventually get to the point when you can decide if you want to work or not.
One trick pony?
Annuities have their problems for sure and there are other options, but I wont drone on any longer. You give yourself more options by seeking independent advice from a financial planner, who will work to keep as many options open for you as possible (and sensible).
Please send me your questions!
That wasn’t so bad was it… any questions?
Dominic Thomas: Solomons IFA
What’s your pension really worth?
Michael Buerk, still working at 67 fronted the Channel 4 Dispatches programme asks what pensions are really worth. The programme which was shown last night can be viewed online. Sadly it was fairly predictable, with headline statements and little helpful information.
The programme began asking what three people expect from their pensions – in terms of the income that they need to have the lifestyle that they want, speaking to an “expert” they come up with some rather all-too simplistic “numbers” in terms of how much they need to pay in. This is what I might generously describe as an impoverished discussion. The only message that was conveyed really was that you need to figure out how much you need and start saving early.
Options and Choices
The question was posed about annuities and the appalling number of people that do not shop around for the best deal. I have every sympathy, but also wonder what it takes for people to realise that that they always have a choice. There was a sorry tale of a man that had a small pension pot (£29,000) and he bought a single life annuity from Scottish life, he then died and the annuity stopped. The family were surprised. I have to say that Scottish Life were incredibly generous in offering to alter the annuity to a joint-life annuity retrospectively. Brownie points to them. However some couples really need to think a lot more carefully about decisions that effect them both and not simply leave it to the other to “sort it out”. Which is why I do not see couples separately.
What About Proper Planning?
Despite phoning around, Mr Buerk failed to really communicate the need for expert advice – from a financial planner who would engage with the income requirements into the future and all of the options. Simply phoning around for the best deal is not good enough, it is better, but still grossly inadequate. Ros Altmann’s appearance was all too short, someone that genuinely understood the issues was not given sufficient air-time. This was typical lip service to educational information and rather more to do with headline grabbers.
Pensions Liberation is a Scam
There were further partial truths thrown in for good measure, a brief bit about pensions liberation – which breaches HMRC rules, so I would describe as illegal and yes it is possible to find someone somewhere to arrange one for the right fee (as with anything else). Frankly in the time available it would have been better to have had a separate show for this topic. Pension liberation can lead to complete financial wipe-out. It is a scam.
Pensions v Property (yawn)
So the alternative to pensions? Well thankfully the report didn’t suggest property purchases were the solution (other than the property expert). Property prices are baseless and fuelled by unsustainable debt. There was no mention of taxes, running costs, insurance etc all of which need consideration for using property as an investment. Certainly there is a place for it for some clients, but as part of the solution not the entire solution. In an ideal world your income in retirement is derived from several sources.
Education, Thinking and Planning
The programme ends with the challenge for us all to think about what we need and to consider how we are going to get there. Sadly no mention of the real “experts” to help with this process – financial planners like me. Who are not paid to sell products but to build a financial plan around real lives and real values. I wonder if the Government, regulator and media will ever get it?
Dominic Thomas: Solomons IFA