PensionsSep 24 2014

Early retirement – embracing change

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Following the announcement of the “freedom and choice” that will be available to retirees after 6th April 2015, the sales of annuities have fallen by a third and those of drawdown have risen (1).

We consider the reasons for this and whether it is a trend that is likely to continue past April 2015.

Falling annuity rates

Much of the current disillusion with annuities is due to the fact that annuity rates have been declining fairly consistently since 1980 (2) however this should not outweigh the suitability of the contract for an individual with the specific objective of providing a known, and accepted, amount of income for the rest of their life. It does however provide a reason why it might be advisable for some individuals to delay purchase until they are older.

Annuity pricing is highly dependent on predicted life expectancy and one of the major reasons that rates have fallen so much is the fact that this has risen considerably. Logically, if an individual wants to get the same sort of deal that a 65 year-old was offered 30 years ago they should buy the annuity when their life expectancy is similar; in other words they have to wait until they are older. It is also possible that a better deal will be available at a later age due to health issues.

Dealing with change

Due to increases in longevity it will not be uncommon for people to spend up to 30 years in retirement. Given this fact it is hard to make a one-off decision that will be suitable for the rest of an individual’s life. Even with the new flexibilities which allow annuity income to change – the manner of the change will still have to be set when the policy is set up.

It is of course impossible to know exactly what will change during this period, but it is fairly certain that something will, and it is also possible to consider scenarios which appear to be likely for that client.

Flexible working

More and more people are retiring gradually, working shorter hours or fewer days in the week. For most people this will be a temporary situation and at some point working hours will probably cease altogether.

If income requirements remain broadly similar throughout this period then pension income is required to top up the reduced earnings during the period of part time work and then replace them altogether in the future. As the annuity market develops it may be possible to specify a step up in income at outset, but this still supposes that the client’s life changes exactly as planned.

A much better solution is to leave the client’s options open by phasing retirement, and still further income flexibility is possible if the crystallised money is phased into drawdown.

Changing income needs

Even after an individual fully retires their income needs are likely to change over time. Obviously the way in which this happens will vary considerably between individuals but a common pattern is the “m-shaped” (3) income where individuals increase their spending during the early part of retirement, reduce it during the middle as they become less active and then increase it again when health becomes an issue.

An annuity is not designed to cope with these changes, especially as the timing is not easy to predict, but drawdown is ideal. The rate of income withdrawal can be easily re-set whenever income needs change.

This flexibility also makes it possible for an individual to manage their income tax. Using drawdown it is possible to manage the exact amount of income taken each year and ensure they remain within a particular tax band. Any client who is concerned about their income tax bill should seriously consider using drawdown when they come to retire.

Health issues

Healthy Life Expectancy (HLE) is not increasing as fast as life expectancy, meaning that more retirees will face physical or mental health issues in the later part of their lives. At this point the flexibility of income drawdown allows the client to take a number of different courses. In the event that their mental capacity is declining it may be worth securing their income through an annuity so that no ongoing decisions are required.

If the issue is physical it would be worth taking advantage of the enhanced or underwritten annuity rates that are available. Alternatively if life expectancy is extremely short the individual could decide to take their remaining fund as a lump sum withdrawal, or they could remain in the drawdown plan in order to pass on their fund to family or friends (4).

Continuing investment opportunity

By choosing drawdown a client is electing to remain in the investment market, which could be seen as a negative or a positive depending on the client’s attitude to investment risk.

On the positive side retaining an exposure to stocks and shares increases the chances of further growth in the fund value. This in turn will increase the amount of income that may be taken either immediately or at some point in the future. Clients who find the annuity that is on offer when they first retire is insufficient to provide the income level they would like to have should consider further investment to try and improve it.

Investment returns can also be used to offset the effect of inflation which can result in the real value of income being almost halved in real terms during retirement (5).

On the other hand remaining invested means the client is exposed to potential losses which would have a detrimental effect on income. This would be particularly pronounced if the losses occur in very early retirement. Clients who have very little capacity for loss would generally not be suitable for this approach.

Scottish Life is ideally placed to help you with these and other pension planning opportunities. We are a pension specialist company with over 70% of the external linked freestanding drawdown market (6), you can be sure of our ability to help you handle income drawdown with confidence.

Fiona Tait is Business Development Manager at Scottish Life

For more information on our drawdown product please visit www.scottishlife.co.uk/headon or call 0845 60 40 800.

1 Source: ABI statistics Q2 2014 The UK retirement income market post budget

2 Source: Ned Cazalet “When I’m sixty-four” Chart - trend in IRRs since 1980.

3 It is also referred to as the u-shape, or “retirement smile”, depending on which part of the pattern is being viewed

4 The latter options would result in a tax charge, however the fact is it is advantageous to have a fund upon which they CAN be taxed

5 Source: Ned Cazalet “When I’m sixty-four” An annuity income of £10,000 bought in 1994 would now be worth £5,600 if reduced by RPI over this period

6 2014 Royal London and Association of British Insurers figures for external unit linked drawdown transfer business

For professional advisers only

The tax situation will depend on personal circumstances and could change in the future.

Scottish Life is a division of the Royal London Group which consists of The Royal London Mutual Insurance Society Limited and its subsidiaries.

The Royal London Mutual Insurance Society Limited is authorised by the Prudential Regulation Authority and regulated by the Financial Conduct Authority and the Prudential Regulation Authority. The firm is on the Financial Services Register, registration number 117672. It provides life assurance and pensions and is a member of the Association of British Insurers and the Association of Financial Mutuals. Registered in England and Wales number 99064. Registered office: 55 Gracechurch Street, London, EC3V 0RL. Royal London Marketing Limited is authorised and regulated by the Financial Conduct Authority and introduces Royal London’s customers to other insurance companies. The firm is on the Financial Services Register, registration number 302391. Registered in England and Wales number 4414137. Registered office: 55 Gracechurch Street, London, EC3V 0RL. Royal London Corporate Pension Services Limited is authorised and regulated by the Financial Conduct Authority and provides pension services. The firm is on the Financial Services Register, registration number 460304. Registered in England and Wales number 5817049. Registered office: 55 Gracechurch Street, London, EC3V 0RL. The Royal London Group registered VAT number is 368 5244 27. 2TAD0510