It’s a wrap as Sipps set to soar

The move in 1990 to give people the flexibility to choose their own pension investments through Sipps has been hugely popular, and the pension freedoms that come into force this April will significantly boost the market. In fact, it could double in size over the next couple of years as investors embrace Sipps as the vehicle for income in later life and for estate planning.

While using a Sipp for drawdown is nothing new, the practice is not currently widespread. Roughly 80 per cent choose to purchase annuities at retirement and the market is worth some £12bn a year. The remaining 20 per cent enter drawdown, either linked to some type of life company combination of wrapper and product, or from their own Sipp.

The new pension legislation with its removal of the cap on withdrawals and changes to tax rules on death is a massive change. To really understand the impact of this on the Sipp market, one needs to consider how the market developed.

The Sipp market grew as defined benefit pension schemes disappeared. People with generous DB schemes do not need to connect with their pensions. They do not carry the investment risk and know the value of their future pension for life. Their hopes and fears are pinned on their employer to sort it out.

As defined contribution pension schemes became the norm, the Sipp market started to grow. People started to actually think about their pensions and they suddenly, unpreparedly, began to carry the investment risk and the uncertainty around their future pension income. Sipps became the natural choice for a growing number of people, especially those who did not want a life company deciding how their pension savings were invested. They wanted to control where the money was invested.

Sipps opened up the market by providing a means of unbundling the investment management. The Sipp wrapper ensured that all pension scheme legislation was properly followed, leaving individuals free to choose their own investments.

Historically, people did not even look at what they had in their pension pots and by the same token, they did not understand or look at their options at retirement. At retirement, they almost certainly did not want to read the very long document they received with their options inside it. Many pension products simply put people into annuities by default in response to this inertia.

Under the new pension legislation, people will receive a much clearer and far more concise wake-up pack at retirement age. They will be able to clearly see their options and be offered guidance. They will be directed to the Pension Wise area of the government’s website and receive a leaflet from the Money Advice Service.

In April, thanks in part to pensions minister Steve Webb’s unfortunate Lamborghini comments, the majority will wake up to the realisation that reaching retirement age does not necessitate the purchase of a new financial product, sometimes from a restricted list. It is hoped that the new pension freedoms will finally end the disconnect between savers and their pension pots, encouraging people to think about all their options extremely carefully.

As state retirement age edges closer to 70, many people begin to wonder whether they will ever receive a state pension. Conversely, many do not want to retire.We are staying fitter for longer and retirement is almost an outdated picture of later life. Many choose to remain gainfully employed, perhaps part-time, or volunteering to the same extent.

So let us forget the word retirement. For many it is “so next year” that it will never happen. The big question is, at what age will our capital need to be turned into income to meet a lifestyle shortfall, as a result of leaving employment or from just deciding to work fewer hours.

The big decision will be how best to meet that shortfall from the range of assets, products pensions and Nisas/Isas at an individual’s disposal. That is where it gets tricky. Before pension freedoms, life was pretty simple, the pack from your insurer came at your selected retirement age and offered you an annuity. Most people just ticked it.

It is all about income. People will still retire with a pot of pension money from which they need to meet their spending goals and cover their essential budget requirements, until death. But life is not simple any more and life expectancy rates have risen. The concept of fixed retirement ages with the prospect of, or requirement for, a constant level of pension income thereafter is no longer likely to fit the majority of people for either affordability or lifestyle reasons.

Annuities have also become exceedingly expensive in this post-credit crunch, quantitative easing-driven, low-interest rate environment. All these factors will lead people to consider more flexible retirement options.

While annuities offer surety of income for life, are relatively easy to understand and largely risk-free, the major drawback and lack of reward lies in their inflexibility.

Value

With annuities, at retirement you surrender a capital value to the insurance company in return for guaranteed income for life. Many risks such as longevity and falling income, are transferred to the provider. One has peace of mind but all value may be lost at death. Annuities, unless purchased with guarantees, may have no residual value in the case of premature death.

With drawdown, the risks of longevity and falling income may mean that capital value is depleted prior to death. One needs to give serious consideration to some type of longevity protection, one’s capacity for loss and in particular the ‘sequence risk’ effect of big losses in the early phase of drawdown.

The risk of further changes in legislation cannot be ignored, particularly in an election year. By way of an example, tax-free cash was officially renamed ‘pension commencement lump sum’ some time ago, potentially paving the way for its beneficial tax status to be crimped or even removed in the future.

The major advantage of a Sipp is its flexibility. As lifestyle changes occur, the income level being drawn down in a Sipp can simply be adjusted. One is not tied into a fixed income level. Obviously, these rewards are not without risk. One may live longer than expected, investment returns may be lower than expected and the pension pot might not provide enough income.

However, the last Budget put Sipps into a truly advantaged position by allowing them to be passed on to any beneficiary, tax-free at death. By allowing uncrystallised lump sums held within a Sipp to be passed on before the age of 75, investments can continue to grow in a tax-free environment until being drawn by the beneficiary, again, without any tax liability at any time.

Sipps are arguably more consistent. They allow people to keep funds invested in the same suitable investments. Consider a Sipp investor in a risk grade five portfolio which has provided an impressive long-term risk-adjusted return. Does the passing of one day, retirement day, categorically mean these investments are no longer suitable? Using a Sipp to facilitate drawdown means funds can remain invested in the same suitable investments. It has been the norm for pension funds to switch into annuities or other products at retirement age, with little regard to prevailing factors such as market conditions or individual circumstances.

The flexibility of Sipps during the accumulation phase of a pension pot has been embraced, and in drawdown Sipps enable the same investments that formed part of the pension accumulation phase to be kept. This may be highly advisable in the case of certain assets, namely commercial property.

Drawdown options within Sipps will continue to evolve, ingenious investment solutions will be launched with guaranteed income, varying income options and different degrees of guarantee risk. The platform Sipp market will continue to be extremely buoyant.

Patrick Ingram is head of corporate partnerships of Parmenion

Key points

The move in 1990 to give people the flexibility to choose their own pension investments through Sipps has been hugely popular.

Sipps opened up the market by providing a means of unbundling the investment management.

Sipps allow people to keep funds invested in the same suitable investments.