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Pension freedoms transformed the opportunity for clients to access previously ‘locked’ pensions and pass on wealth held in their retirement fund. Where they once faced a punitive ‘death tax’, they can now pass on pension wealth tax efficiently. This creates a huge opportunity to hand a valuable income stream to loved ones. Three years on, however, it’s unclear if retirees are making the most of this flexibility by choosing the right investment solution to help defend their inheritance against market shocks and inflation risks.
Taking the wheel
When George Osborne introduced reforms that meant no-one would be forced to buy an annuity, the retirement choices available to clients changed beyond all recognition.
Since then, retirees have been able to access their pension pots from age 55 (or whenever scheme rules allow). The initial fears of retirees blowing their pension pots on fast cars and exotic holidays – leaving them to rely on the generosity of the state – have not yet come to pass. Nonetheless, figures from HMRC show that some Britons are cashing in their pensions. Between the arrival of the pension freedoms in April 2015 and the end of March 2018, some £17.5bn was paid out in flexible pension payments. As this flexibility to access your pension pot is only available to members of defined contribution (DC) or money purchase schemes, it’s little wonder that the Office for National Statistics (ONS) recorded a surge in pension transfers to other schemes of £36.7bn in 2017.
Inherited wisdom
One of the key factors driving this move is the ability to pass on your pension as an inheritance for your loved ones. In a DB scheme, there is no fixed “capital” that can be passed on, although spouses or dependents may still receive a reduced income after your death. Likewise, an annuity may provide spousal benefits but leaves no capital on death.
But within a DC scheme, should the pension holder die before age 75 the beneficiaries can take the pot as income or as a lump sum tax free, subject to lifetime allowance limits. If the death occurs after 75 the income or lump sum is taxed at the beneficiaries’ marginal rate of income tax, not the shrivelling 55% charge that was previously in place.
This ‘death tax’ as it was frequently described had always been sufficient to deter most UK pension savers from making plans to pass on their remaining pension pots. By contrast, today’s pension regime now offers advisers an added opportunity to add value through inheritance and estate planning. So how can an investment solution used in decumulation play a role in meeting retirement income needs, as well as being part of the intergenerational planning process?
Going the distance
These days there are ample opportunities afforded by the new pension freedoms to ensure that the pension pot your client spent their entire adult life accumulating does more than just provide an income
for them in retirement. With the proper care and attention it can actually deliver all the income and occasional lump sums they might need and still survive to be passed on to the next generation and the next.
Ian Browne, head of retirement proposition marketing, Quilter, says: “It is always a good idea to recommend clients agree to a ‘what if…’ plan. Within this will be agreed actions if something happens. For example, the plan would look at potential one-off capital expenditures (such as the boiler breaking down) and where the money will come from to pay for this. It will also look at situations like a stock market crash or the death of a partner. Agreeing to a plan like this in advance will help if these events happen. You and your clients can react quicker. This prevents the situation getting worse through procrastination.”
Strategy and objectives
But as well as a contingency plan, there also needs to be an overall strategy for the decumulation phase and the objectives your client wants to meet, such as leaving an inheritance for their children or grandchildren.
Research from the FCA’s recent Retirement Outcomes Review revealed roughly 33% of non-advised customers in drawdown were only holding cash. The FCA says more than half of these are losing out on income in retirement and many could experience a significant downside due to missing out on investment growth. According to the FCA, someone drawing down income over a 20-year period could increase their annual income by 37% by investing in a mix of assets rather than holding cash.
Withdrawing the whole pension pot and placing it in a cash savings account when interest rates are at near record lows and inflation is hovering well above the Bank of England’s 2% threshold, is a one-way ticket to disappointment for UK retirees.
It is therefore clear that consumers need much more support and advice in developing the right decumulation strategy that can take advantage of these new opportunities without leaving them exposed to avoidable risks.
Caught in the headlights?
The temptation for clients worried about risk in retirement is to flee to cash. But figures from the Bank of England show inflation in the UK was an average of 2.8% a year over the decade to 2017. If we assume that this rate of inflation acts against a pension pot of £250,000 for a period of 20 years, with no other reductions the pot would be worth just £141,666 after 20 years – a significant reduction in purchasing power for any beneficiaries.
From this perspective, it’s clear that some level of investment risk is needed to maintain the value of any pension inheritance, let alone increase its value. The key is to find the right balance between income, capital preservation and active downside defence against market volatility. Although developed equity markets have been in an ongoing bull market phase for the past decade, there is no certainty as to how much longer this will continue. And with geopolitical events lurking around the edges, from Brexit to Trump’s trade wars, a certain level of investor reticence is to be expected.
This is where advice becomes most important, as in addition to inflation and longevity risks – the potential to outlive your savings – a key issue for investors is the possibility that they experience a large loss at the start of their decumulation phase and don’t have the time to make up the shortfall. This is commonly known as sequence of returns risk. Therefore protecting capital against shock market events becomes at least as important as generating strong returns. By articulating these risks and taking steps to mitigate them, advisers can add value to clients while also maximizing the opportunity of them being able to pass on pension wealth.
Consistency is the key
Consistency becomes the key component, through a portfolio of solutions that can provide active downside defence and help mitigate market falls by diversifying the investment pot, while at the same time delivering a steady and consistent income stream.
With a limited investment horizon, and clear objectives, investors aren’t looking to shoot the lights out with returns, instead generating sufficient income to cover expenses, provide a buffer against inflation growth and help minimise the effects of market falls become the most important aspects of their decumulation strategy.
And through the retirement planning process, clients may choose to blend solutions to create the right mix, whether that includes some cash for a rainy day, a portion invested in an annuity, or a globally diversified, multi-asset portfolio that looks to balance risk with rewards. Together these can help to safeguard as much, or as little, as the retiree wants to pass on to their beneficiaries, and by holding some or all of their savings in a solution designed to balance long-term growth with capital preservation, clients will also be passing on those characteristics when it is inherited. Clients may find that appealing compared with handing down a more volatile portfolio of equities, which may not encourage loved ones to stay invested, especially if they haven't experienced investors themselves.
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