PensionsJun 5 2013

How to solve the ‘risk paradox’

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      In practice, it means that if someone has a small DC pension pot to invest but has other pensions such as a final-salary pension, they may be in the position to consider an investment-linked annuity if they are prepared to take the associated risks.

      Options

      Those with above-average-sized pension funds have more choice, but realistically the alternatives to guaranteed annuities are not viable unless the pension fund is more than £50,000 and the investor has other sources of income or pensions.

      One of the advantages that this group has is that they can consider investing in more than one type of annuity or drawdown policy.

      In addition to the options mentioned earlier, those with above-average-sized pensions may consider the options in table 2.

      AdvantageDisadvantageComment
      Fixed termIncome fixed for a set period and guaranteed maturity fund value at end of term.If annuity rates are lower at the end of the term, investors will get a lower income.Fixed term has become more popular and if your health has deteriorated you may qualify for a higher annuity. However, they are risky.
      Investment linkedAnnuity with potential for income growth and flexibility.If investment returns are lower than expected, the income will fall.Three popular options: Prudential, LV=’s with profit annuity and MGM’s investment-linked annuity.
      Pension drawdownNo need to buy annuity as income taken direct from fund. On death there is an option of a lump-sum death benefit less 55 per cent tax.If investment returns are lower than expected the income may fall and fund values reduce. The charges are higher than for annuities.Mostly suitable for larger funds but may be suitable for smaller funds especially if low cost Sipp involved.
      Phased retirementTax-efficient way to pay pension income. Each year part of pension fund converted into tax free cash and income.Can be complicated and only suitable for large funds.For those who can afford to do it, phased retirement is one of the best ways to take your pension when there is so much uncertainty.
      Annuity portfolioThis is a combination of guaranteed annuities and investment-linked flexible pensions.If investment returns are lower than expected, the income may fall and fund values reduce.This can be done with medium-sized funds and enables you to have a combination of guaranteed and flexible annuities.

      Gilt yields and annuity rates may rise in the future but investors may have to wait several years for this to happen, so it might not make sense to defer an annuity purchase hoping that rates will get better. In fact, things may get worse before it gets better.

      There are other options to a guaranteed annuity but these do carry risks and taking a modest amount of risk may not be a bad thing.

      Those approaching retirement are facing the ‘risk paradox’. Put simply, many people think that investing in a guaranteed annuity is the lowest-risk option and, in a sense, because the income is guaranteed not to change, it is risk free. But in the future, there is the risk that the spending power of a level annuity will be eroded by inflation and a pensioner’s circumstances may change.

      Therefore investors may have to take some risk with their annuity income in order to end up in a better position. This is a hard message to sell and full of potential dangers, but it is an important message that deserves more debate and analysis.

      Finally, in times of so much uncertainty it might make sense not to put all of your eggs in one basket and spread your risk. I call this a portfolio annuity and this can range from a simple combination of guaranteed annuities to a more complex solution, including drawdown.

      Billy Burrows is director of Better Retirement

      Key points

      ■ In the longer term all pensioners are faced with a number of unknowns.

      ■ Investors should have other sources of income or capital to fall back on if the future income from an investment-linked option falls in value.

      ■ Gilt yields and annuity rates may rise in the future, but investors may have to wait several years for this to happen.

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      1. A guaranteed annuity might meet pensioners needs today but it is not flexible and cannot be changed in future circumstances change
      2. How big is the average sized pension pot?
      3. Which is an option not considered by the author?
      4. Having another source of income or capital is important
      5. Alternatives to guaranteed annuities are not viable unless the pension fund is over how much?
      6. What is the main danger of a guaranteed annuity?
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