Your IndustryApr 22 2015

Different sources of income in retirement

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Guarantees

From next year the state pension is being overhauled with the launch of a flat rate state pension worth around £150 a week.

It is designed to provide a basic level of income but at around £7,800 a year, Simon Massey, wealth management director of MetLife, says this should be seen as only part of pension provision.

Since 6 April and greater access to pension pots and what people do with their cash being granted, many have have heralded the death of the other main source of guaranteed income: annuities.

But Andrew Tully, pensions technical director of MGM Advantage, says it is important to recognise these products can now also offer a ‘moneyback guarantee’ since flexibilities announced in the Autumn to reflect the more liberal pension income regime.

He says this means one of the main concerns about annuities has been fixed, meaning customers can now get great value from their annuity whether they live or die. Guarantee periods can now be unlimited instead of 10 years - and income is fully variable over the life of a policy.

Mr Tully says: “This gives families peace of mind that the money invested in providing a secure income won’t be lost and removes the understandable sense of financial injustice that can sometimes be felt when a holder dies early.

“However annuities have less flexibility for future change than income drawdown, although investment-linked annuities do give more flexibility as well as the traditional advantages of annuities.”

Drawdown

Drawdown is the obvious alternative to an annuity, representing the opposite end of the risk and flexibility spectrum. Clients remain invested, meaning they benefit from growth but are exposed to underperformance, and can take as much or little income as they choose.

Drawdown offers the ultimate flexibility so people can adapt their retirement income to suit their changing needs, Mr Tully says. Under new rules there are no more minimum income requirements or caps, but some providers may set a minimum threshold to process business.

Mr Tully says customers in drawdown take on investment and, in particular, longevity risk, meaning there is a real potential that people can run out of money before they die.

On the flip side they can invest in the sort of multi-asset funds that have traditionally been the preserve of younger investors and, if all goes well, they could benefit from significant growth and generate a higher income than they might otherwise.

Early indications have suggested that many of those calling providers in the wake of pension freedoms are seeking to find out more about this option, so it is likely to continue acceleration in sales witnessed at the end of last year.

Property

Property may also be attractive to people as they believe they can see and trust bricks and mortar. Of course most advised clients will already have a substantial property investment, which provides both a reason to consider making additional purchases and also another potential income source.

The baby boomer generation at and approaching retirement are thought to control around a third of property wealth in the UK. The average property is now worth more than £270,000, according to the Office for National Statistics, giving a real option to those seeking an additional source of income.

Most equity release schemes will offer cash lump sums in return for a share of the property and don’t compromise residence, although they can be pricey with AERs of 5-6 per cent and so the amount owed can increase significantly over time.

Equity release lending reached a record £1.4bn in 2014, according to the latest industry figures from the Equity Release Council, exceeding the previous high of £1.2bn in 2007 by 14 per cent and equating to a 29 per cent increase compared to 2013. .

The option of taking a regular premium to offer annuity-style income from a property is also becoming more popular, with two-thirds of new equity release customers choosing drawdown products last year, in contrast to just 25 per cent in 2006.

Another way of accessing property wealth for those not keen on the rates to release equity, is downsizing, which is set to boom, according to Old Mutual Wealth’s Adrian Walker. He said only 2 per cent of retirees use it to generate income but 15 per cent approaching retirement expect to.

And what about the much maligned option of using pension wealth to buy a buy-to-let property? Despite the commitment it entails, buy-to-let is also set to increase from 6 per cent usage to 15 per cent usage as an income source, Mr Walker adds.

Yields are impressive and buy-to-let has smashed other asset classes over the last 18 years, beating equities by 50 per cent and returning more than £5,000 on a £1,000 investment according to Wrigglesworth Consultancy figures.

For pensions the sticking point could be tax. Money is taxed on the way out and all income for the remainder of the year could be subject to a high marginal rate, while stamp duty and capital gains tax on a future sale will also eat into returns. Void periods and other costs are a factor, too.

‘Third way’ options

According to MetLife’s Mr Massey evidence from other countries with well-developed private pension systems suggests most people choose freedom and flexibility rather than the lifetime guaranteed income of standard annuities, especially after the falls in interest and annuity rates of recent years.

But he points out even in countries ahead of us in embracing freedom to do as you please with your pension, some form of guaranteed income still forms the basis of most plans.

He says: “Annuities will not be suitable for everyone - and certainly not buying a standard annuity with the entire pension fund, which offers no inflation protection, no provision for a partner and cannot be adjusted if health or market conditions changed in future.

“Increasingly there will be more flexible annuities launched – and indeed savers who already have annuities may be able to trade them on the proposed secondary market from next April.”

People’s retirements are now more U-shaped or J-shaped with a need for income at the start which then drops before rising again later in life when people need care, he points out.

Mr Massey says: “Financial advisers tell us that guarantees on income and capital will be more important.

“They believe that the new pension regime is likely to increase the use of guaranteed products, that are more flexible than annuities, but less risky than income drawdown.”

Conventional annuities and drawdown both have considerable risks and Mr Massey says that is why MetLife believes the potential market for guaranteed products will grow considerably.

He says the guaranteed drawdown market - also known as ‘third way’ or ‘variable’ annuities - will grow to be worth £48bn by 2023, according to research by consultants Spence Johnson.

Working longer

And while we’re talking about funding longer retirement, it is equally clear more people are also working past traditional retirement ages to shorten the period and increase saving potential. Mr Tully says this seems set to continue.

He says: “It is great that people now have the ability to work longer if they wish to, and many will want to gradually reduce their hours as they get older.

“But, unfortunately, for some continuing to work is more a matter of need rather than choice – which demonstrates the real value in saving for retirement and then using those savings to produce a retirement income.”

Adrian Walker, retirement planning manager at Old Mutual Wealth, says 11 per cent of today’s retirees work part time but 30 per cent of those approaching retirement aged over 55 are expecting to work part time.

Mr Walker says this may be a result of the decline in final salary pensions, which only 33 per cent of pre-retirees polled by Old Mutual Wealth back in December 2014 thought they had compared with 50 per cent of people already retired who have this type of pension.