William Burrows returned to The Retirement Café podcast to continue our conversation about pensions. We discuss pension freedoms and the growth of drawdown. You can listen to my interview with William Burrows on The Retirement Café podcast here
What’s pension freedoms?
In 2015 new legislation – The Pension Schemes Act 2015 – took the pensions market by storm. Known as ‘pension freedoms’, the new rules gave you more options as to how to take your pension savings.
With pension drawdown, it’s really simple. You leave your money in the pension pot, you invest it in the stock market, then you draw either a regular income, say monthly or quarterly, or ad hoc payments.
You simply take income out of the pension pot and then when you die, any money left in the pension pot can be left to the family.
One of the paradoxes about drawdown is it’s really simple to understand. You’re just drawing money out of your pension pot, but it’s probably one of the most complicated arrangements to set up and to manage properly.
It’s difficult and complicated to manage, because there are so many different risks. There’s a risk of running out of income, there’s a risk of investing in the wrong place, there’s a risk of inflation, there’s a risk of changing circumstances.
The three pot approach
One method of creating an investment strategy in retirement is the three pot approach.
You have a pot of money in cash or very low risk that’s going to provide your income for the next couple of years. Then you have the core of your investments, and this is really important, which account for maybe 75%, which needs to be in a properly risk rated, diverse portfolio.
And because you’ve got some money in cash, because you’ve got your core risk rated, it means that you can probably actually have a little bit in a growth fund. So the third pot is the growth pot.
Small pension pots
If you’ve got a relatively small pension pot, there’s no reason why you can’t take advantage of drawdown. There are some really good products from some of the insurance companies, Royal London and Prudential, for example, that have very good, relatively low risk, low maintenance drawdown plans.
An income throughout your retirement journey
The retirement journey starts off, let’s say, at 60. And at 60, most people, understandably, want to be in control and to make decisions. So, it’s understandable why you may be in drawdown.
You then have the middle part of retirement, this so-called U shaped income curve, where you may need less income. Then eventually you end up with later life, where, really, you shouldn’t be taking any risk and you’re more concerned about maybe long-term care issues.
You have this retirement journey and at any point of this retirement journey there are two things happening. There is all of the complexity and technical stuff that we know about. But there’s also a lot of behavioural stuff and emotional stuff going on.
As you go through retirement, you should be doing two things. Firstly, you should be looking at making sure that you can meet your income requirements. And secondly, that you’ve got the right risk profile and the right attitude to risk.
In a nutshell, as you progress through your retirement journey, you should be taking less risk. And an important strategy in that de-risking is to think about buying annuities.
The role of mortality drag
The technical bit is the so-called mortality drag, mortality cross subsidy. There is a concept, which we talk about – maintaining your annuity purchasing power. Let’s say you’ve got £100,000 at 60. You could buy an annuity that would give you around £4,000 a year.
By the time you get to 65, if you’ve been drawing the £4,000 from your pension pot and two things will have happened. Your pension pot hopefully will have grown, and you’re five years older.
But can that pot in five years’ time still buy the same annuity income? Now, because of the mortality cross subsidy, there is a real paradox here. The older you get, the greater the investment returns you need in order to maintain your annuity purchasing power, at exactly the point in life where you should be taking less risk, not more risk.
Leaving an inheritance
I find that once people start getting older, leaving an inheritance becomes really important. But what’s more important is to make sure that there’s enough money in your pension pot, in your assets, to ensure that you’ve got enough income for your needs.
Pension freedoms has fundamentally changed pension planning
Any money left in a pension pot can be left to any beneficiaries you wish.
There is a tax element to it. If you die before age 75, your beneficiaries don’t have to pay any tax at all on any money they take out. If you die after the age of 75, then your beneficiaries will pay tax at their marginal rate on any income or lump sums they take out.
It’s all about the plan
The most important thing that people like me can do with our clients is to help them think about the long term. The better the planning, the better the results.
Although you need a plan, it doesn’t always have to be terribly sophisticated. A basic plan is better than no plan at all. But you’ve got to have a plan.
Then, when you’ve got the plan, you need to think about tactics, which means things like annuities and drawdown. The most important thing is to get a plan.
As we know, plans dissipate very quickly with real life moves on and families change, circumstances change, the tax rules change and health changes, but it’s still not a reason to not have a plan in the first place. Because that’s the true benefit of a plan; it becomes adaptable and changeable.
The tempting short-term view
It’s very tempting nowadays – and pension freedoms hasn’t helped – for people to think about the short term. I don’t want to buy an annuity, because I can go into drawdown, and I’ve got access to the income.
But retirement is a much longer journey than people expect. And certainly, as you get older, it’s more important that people have this, what I call, peace of mind and security. And that’s code for knowing that you’ve got enough money in the bank or in your pension pot, or in your investments, that no matter what comes along, you’re always going to maintain your standard of living.