Gone are the days of final salary schemes where employers bore the cost and risk of meeting a promised pension.
With the exception of the state, few employers are able (or willing) to offer these schemes now.
This leaves individuals responsible for ensuring their pension pot lasts as long as they do, writes Nigel Orange, technical manager at Canada Life.
Securing an income
Up to the point of retirement, the greatest pitfalls employees in defined contribution schemes face are under-funding and poor investment choice.
At retirement, however, the stakes get raised and the risks include:
- Selecting an unsuitable retirement product;
- Running out of funds prematurely;
- Living too long;
- Prolonged low or negative investment growth; and,
- Sequential risk (making income withdrawals when markets are falling).
Purchasing an annuity
One way to counter these risks is to secure an income for life.
Despite suffering some bad publicity around value for money, annuities remain the most suitable option if a secure income in essential to meeting everyday living expenses and no other source of income is available.
But that does not mean they are risk-free, with retirees in danger of:
- Locking into a low rate and low income;
- Locking into a product that can’t be changed even when personal circumstances may change significantly;
- Over-paying for inflation-proofing which could be achieved through investment growth; and,
- Purchasing too early – higher income can be achieved at older ages, particularly when health becomes a factor. (Although purchasing an annuity can be deferred and bought in tranches when deemed better value (rates improve and or health deteriorates).
Sensible steps
The risks in drawdown can be managed or mitigated to some extent.
Sequential risk is potentially the most damaging in producing a bad outcome.
Cashing in units to pay out income at a time when markets are falling can seriously deplete a pension pot.
However, this can be partly mitigated by ensuring sufficient cash is held at all times to pay a regular income.
The downside being holding too much cash lowers overall returns.
Other important factors to consider include:
- Running out of funds prematurely, which can be managed by ensuring withdrawals are kept below 4% and by monitoring the investment performance.
- Living beyond the average mortality age should be a cause of celebration but in financial terms this can be result in an unexpected depletion of funds – purchasing a deferred or fixed term annuity may help manage this scenario.
- A prolonged downturn in global stock markets is less likely than this event in individual markets such as the FTSE, so having a global portfolio can help mitigate this particular risk.
- It is possible to protect capital by using protected funds that lock in gains but when stock markets are volatile the fund charges can be prohibitive.
- Funds can smooth out gains and losses in the same way as with profits and are popular because they take out the roller coaster type experience most investors dislike, but again costs can be an issue.
A versus B versus C
When it comes to choosing a retirement option it’s not that easy because each has its pros and cons, with different inherent risks.
In truth, individuals tend to get more conservative as they get older, so more cautious when investing.
Unfortunately, this tends to limit growth potential and, therefore, the ability to inflation-proof income; meaning that if inflation proofing is important then a more balanced portfolio may be better.
In recent years, having the facility to phase tax free cash and minimise tax has been high on a client’s needs list.
The features that most retirees value most are:
- Secure income for life;
- A growing income that mitigates inflation;
- The ability to phase tax free cash;
- Flexibility; and,
- Value for money.
Building a relationship
What’s important to recognise is that individuals should be able to determine their priorities – how much secure income they need immediately and how much they feel comfortable investing.
For some, opting to inflation proof income through investment growth may be preferable than forgoing initial income from an annuity. Some flexibility may be given up in lieu of having income security.
Most retirees recognise that compromising to some extent will help them reach a good outcome.
Whatever the choice, making it a stress-free experience, initially and later if changes are required is crucial to a good adviser client relationship.
This article was written for International Adviser by Nigel Orange, technical manager at Canada Life. He is a pensions specialist with over 30 years’ industry experience.
