In a world of change, which way next?

Consider this nugget on security and retirement readiness, for example: while 70 per cent of us want some form of guaranteed income in retirement, the reality is the UK has one of the lowest household savings in the world.

What this means is most Brits will have to retire on less than half of what they want. In fact, only 6 per cent are currently on track to hit their goals.

And the rest? 50 per cent of workers expect to continue working in some capacity after reaching retirement age. More startling still, the research found that, in general, people not only don’t understand what their position is, they haven’t even looked. The findings make sobering reading.

So, in the light of all this insight, which investment strategies and income propositions will rise to take pole position over the next decade?

According to our research, only 2 per cent of financial advisers who responded to the study think annuities will lead the market by 2025. But, as we’ve just mentioned, 7 in 10 people claim that a guaranteed income is still important to their retirement plans. The question is then, how will all this work itself out?

Well, the same research shows that one in three advisers believe risk-managed funds will become the most popular income investment strategy, while one in four pointed to flexible guarantees.

The options available

At a time when annuity sales are declining rapidly, all this suggests risk-managed flexible guarantees could be the new future. A perfect time perhaps to look at the pros, cons and watch-outs across all the options currently available.

Flexi-access income drawdown

Widely considered the rising star, in a nutshell clients can take up to 25 per cent tax-free cash. They can then take any amount from the fund they want to as income. They will pay income tax on this at their marginal rate and the rest remains invested.

So far, so good. As the survey’s findings tell us, this vehicle is likely to be very popular, but this is where the challenges – and need for good advice – begin.

Is there a risk that you will outlive your investment? Based on a client’s attitude to risk and capacity for loss, what is the appropriate investment strategy for the pension not in drawdown?

How might market changes affect things? If you take your money out when the market is down are you are doing irreparable damage to your investment portfolio?

What’s the risk of depleting savings too much, especially in the early years?

Industry energy is going into investment strategies that aim to generate an income while making sure savings aren’t eroded. This should be achievable. Graph 1 shows the average performance of pension funds in UK All Companies and UK Equity Income sectors over the past 20 years. However, income payments create an in-built drain on any savings pot and this has a profound impact on the types of funds that may be suitable.

Graph 2 shows the impact of £1,500 monthly withdrawals, commencing at age 65, on a pot of £300,000, assuming no underlying growth and an annual growth rate of 2 per cent, 4 per cent and 6 per cent. In the projected worst case scenario, the pot would run out before the individual’s 82nd birthday.

Investors no longer have the luxury of time to recover from investment losses. Therefore, managing risk and reducing the impact of market falls is more important than ever.

Of course, some investors may be prepared to accept a degree of risk, with the aim improving long-term growth potential.

Annuities

Typically the traditional option of annuities provides a guaranteed income for the rest of the client’s life, with no investment risk. The downside is that this is an irreversible arrangement.

A key consideration therefore is the potential for changing circumstances. If there are health issues later then you can’t change things.

Again there are other matters to think about. Is there a timing risk in buying an annuity now or in deferring it? What type of annuity is appropriate given the variety on offer? Plus, how will inflation affect things? Is there any risk that the real value of future income payments will be eroded by inflation?

Cashing in

The most hotly anticipated change is the boldest move of all. Your entire pension pot can be cashed in, or you can receive ad hoc payments. 25 per cent of each payment is tax-free and there are no limits on the amount taken.

Any money left in the pension pot will pass tax-free to the individual’s beneficiary where death is under the age of 75 and the amount is within the lifetime allowance.

Again though, it’s an irrevocable decision. Many schemes won’t offer this option and people may have to transfer to another provider to take advantage of it.

Adopting this approach takes clients out of a ‘tax-protected environment’. And risks moving them into a higher tax bracket and a later tax demand, after the money has been spent.

It could also mean the loss of state means-tested benefits, such as housing benefit and just being left with the State pension. Future tax-relievable contributions are limited to £10,000 a year, rather than £40,000.

The greatest risk of all is simply running out of money later in retirement.

Savers with small pots can take up to three pension pots of up to £10,000 each as cash, entirely tax-free. This route allows individuals to continue to make tax-relievable contributions of £40,000 a year.

Further, small pots aren’t counted towards an individual’s lifetime allowance of £1.25m and tiny pots can be consolidated into small pension pots to then be cashed in.

Isas

This is exactly the time of year when clients traditionally think about making the most of their Isa allowance. With the latest investment limit of £15,000, they can put more than ever before into the tax-efficient vehicles. They’ll get tax relief on investment growth and no tax paid on the way out.

There is also the ability to cash in funds and transfer to pensions within the £40,000 contribution limit. And cashing in Isas doesn’t trigger a lower level of saving in the same way it does for pensions.

So, what are the negatives? Isas are not as tax-efficient as pensions, as contributions are taxed, and they won’t provide a regular income.

Unit-linked guarantees

Compared with the other choices at retirement unit-linked guarantees seem to offer more of the upsides, and less of the down, offering income and capital guarantees with flexible access.

But of course, they come at a cost and they can be complicated, so – again – good on-going advice is key.

Blended solutions

Blended solutions, which combine drawdown, annuities, and cash (including small pots) have been widely touted since the freedoms were announced.

This approach is based on individual solutions taking full advantage of the new flexibilities with the ability to manage income tax.

The downside again is potential complexity, so – again – advice is key.

The value of advice

Finally, it is vital to remember that a one-size-fits-all approach works no better in retirement than it does in the early years of saving. The suitability of a fund or portfolio will depend on the value of savings, individual income needs and risk appetite among other things – which is why sound financial advice is so important.

From this month, retiring savers will enjoy greater choice, and there are a number of investment strategies which can help them make the most of their hard-earned savings.

With choice, however, comes complexity. This means solid financial advice is vital in matching all retiree’s needs with the funds that suit them best.

Duncan Jarrett is managing director of retail solutions, Aegon