From transactional advice to retirement planning

Kate Smith, regulatory strategy manager at Aegon, notes: “The pension flexibilities will give people a huge amount of choice but the big unknown for advisers and providers is how exactly will people want to exercise this freedom?

“The retirement income market has, however, changed in one clear way: we’ve moved from a system whereby retirees chose one option such as an annuity or drawdown, to a system whereby people will be able to combine a range of options.”

No longer the effective push into a guaranteed income. More choice; greater flexibility with that choice. So far, so simple.

What is often forgotten, though, is that if pension freedom is moving the ‘purchase’ of retirement income from a simple transactional event to a broader, probably phased financial planning exercise, then it is not all about the pension.

Richard Parkin, head of retirement at Fidelity Worldwide Investment, points out that it is important clients think holistically about their needs and all of their sources of income and not just focus on the private pension pot to which access has now been opened.

“You need to think about all the sources of income you’ll have including company and state pensions, other investments such as Isas and maybe even earned income.

“Against this, you’re going to need to offset all of your financial needs remembering that retirement can last a very long time and inflation is likely to reduce your spending power over time.”

Meeting essential expenses

Starting at the beginning, any good financial plan in retirement will take account of the essential expenses that are not up for discussion, which where possible guaranteed income we be required to meet.

Prior to last year’s Budget, annuities were by far and away the most popular way to secure income, but since then sales of individual annuities have dropped by around 50 per cent.

Annuities do still have a place in the market, perhaps as part of a package using a portion of the fund to cover a portion of the income need. They could also be introduced later to cover expenses which only become a factor later, such as long-term care.

But guaranteed income is not all about annuities: let’s not forget the state pension. From April next year, a single tier flat-rate state pension will be introduced paying around £155 a week.

The flat rate will give people more certainty and will allow them to incorporate this into their retirement planning. It’s also currently rising at least in line with the highest rate of inflation and for the forseeable future will be increasing in real terms.

This may cover basic bills, or at least mostly, and reduce the need for other secure income, thus freeing up more pension money to remain invested.

There’s also the planning option of using other pension wealth to meet core costs and deferring the state pension, which currently uprates at a rate of 10.4 per cent, or double an average annuity rate. Those retiring from April 2016 will still see an annual uplift of a competitive 5.8 per cent.

Flexible guarantees

Other more flexible options to bring in an element of guaranteed income include so-called ‘third way’ products, which incorporate a core annuity income stream and an invested element which tops this up and gives potential for income to grow with strong performance.

Aegon’s Ms Smith says: “In the US, the variable annuity market is worth $140bn [£93.6bn] each year making it the dominant income product.

“We see VAs, or unit-linked guarantees as they’re known here, playing a far greater role in the coming years as they allow people to keep their pension invested but with a set level of income guaranteed. Unlike a traditional annuity it’s not a one-way decision and customers take their money elsewhere when they want.”

Aegon is one of the three main players in the unit-linked guarantee market alongside Metlife and Axa, however others providers, including specialist annuity provider Partnership, previously told FTAdviser this they are looking at launches in this space.

Invested income

For the rest of a person’s income needs, such as costs to meet an aspirational lifestyle, it might pay investors to keep their money invested as long as they can accept the inherent risks.

A desire not to be stuck with an immovable income stream has lead many experts to predict new ultra-flexible drawdown will replace annuities as the ‘default’ product.

It’s worth remembering drawdown isn’t all about income either: savers can take a cash windfall of up to 25 per cent of the fund tax-free, leaving the remainder invested to provide income.

Clients can also use their residual fund to withdraw ad-hoc sums to meet demand if they have core expenses covered. This can be done through partial withdrawal under drawdown, or through the simpler option that doesn’t require a payroll system, ‘uncrystallised fund pension lump sums’.

Ms Smith explains: “Savings will continue to be invested and only 25 per cent of each withdrawal will be tax free.

“Like the first income payments from annuities or drawdown, the first cash sum payment will be taxed at HMRC emergency rates, which means that initially people will be paying more tax than they expected, but this can be claimed back from HMRC.”

Utilising cash

This is all straightforward, but clients may have particular needs that leads them to seek to take advantage of the broader array of freedoms. An example could be where an individual has significant debt which would free up substantial monthly income if removed.

Mr Parkin says that clients could withdraw cash from their pension, either through one of the ad hoc options outlined above or through a full withdrawal of the fund, to pay off debt, but he says this will probably only make sense if the debt is “relatively costly to maintain”.

He says: “Credit cards and car loans may be good targets while mortgages may be less so. Given low interest rates and the potential impact of reducing debt on estate planning, this needs to be considered carefully.”

If clients are withdrawing large sums or the whole lot, the tax implications need to be considered.

Income is taxed at marginal rates so taking a lot in one year could increase the tax bill. Where a large sum is taken in one go at outset the aforementioned emergency taxes could blow a big hole in the payment which may not be recovered from HMRC for some time.

Housing wealth

Beyond the pension and an essential consideration in any financial plan in retirement is housing wealth. The baby boomer generation which will be the first to enjoy pension freedom is setting on 80 per cent of the UK’s housing wealth; unlocking this could ease pressure to secure income elsewhere.

Again there is a cash and an income option: either downsizing the main residence, which would involve moving, or entering an equity release arrangement, which allows the individual to stay in the property but with the caveat that a mortgage lender will take a share of it on death.

Financial market software firm Iress recently announced it has partnered with Age Partnership to develop an equity release referral service. Adam Carnell, head of partnerships at Age Partnership predicts that the pension changes will make equity release a ‘mainstream product’.

Last year, sales were up 29 per cent, he says, stating that the market will “significantly grow” this year. Legal and General clearly has the same view, announcing that they are set to enter the market with the acquisition of New Life Home Finance.

And while we’re on property, there is the option, widely discussed, of taking cash as described above to secure an income through buy-to-let. By all accounts many will do this, but there are some prohibitive tax considerations which most advisers argue makes it a poor choice for most.

Advice need

As described above, we are likely to be entering an age of blended solutions made up of some or all of the above. If this sounds complex it is because it is, meaning advice should become more attractive and opportunities to add value abound.

Mr Parkin says: “Much of the debate around pension freedoms is around which option is suitable for which type of client.

“But this idea of retirement advice as some kind of Harry Potteresque sorting hat between cash, drawdown and annuity is, at best, naïve and, at worst, downright dangerous. As most advisers will tell you, the answer is a bit of everything.”

Ms Smith adds: “Even the savviest of consumers is going to struggle to get a clear picture of which of these many options will best suit their needs.

“Of course there’s Pension Wise [and] the pensions industry is also providing a range of free tools to help people understand their options, but we see the flexibilities as a huge opportunity for advisers with clients looking to understand the best way to manage their income.”

donia.o’loughlin@ft.com