Time for a retirement reality check

As well as freeing the British public from the ‘shackles’ of the annuity market, the new pension freedoms rules created a huge new market for advisers. There has never been a greater need for retirees to engage with their advisers regularly to ensure their retirement stays on track and that their pension pot survives for at least as long as they do.

This is just as well because when it comes to ‘decumulation’ UK retirees need to come to terms with a number of new realities.

New reality #1: Annuities are no longer for everyone

There are many good reasons why advisers need to spend time explaining the potential benefits of an annuity. However, these days only the wealthiest or the oldest Britons can afford to make a traditional annuity a large part of their pension planning because the cost of the guaranteed income they offer has simply become too high.

The most recent Which? survey revealed that the average retired household spends £2,200 a month, or about £26,000 a year, paying the standard bills and enjoying a modest taste of the better things such as short-haul holidays, hobbies and eating out. This jumps to around £3,250 a month or £39,000 a year for those households that enjoy more elaborate trips, spend a little more and buy a new car every five years.

Using current annuity rates we can illustrate the cost of providing this level of income via an annuity. Don’t forget that our imaginary retiree will also have to pay 20% income tax on the annuity income they receive above the current personal allowance of £11,850, which naturally increases the cost of the annuity.

Consequently, a single life annuity that delivers £26,000 a year, net of tax, and which offers an escalating income of 3% a year (enough to protect its future purchasing power) would cost just under £760,000. Meanwhile, a post-tax annuity income of £39,000 (with matching escalation) would cost a cool £1.17m – somewhat more than the lifetime allowance^[1].

For most Britons approaching retirement, being confronted with such costs will surely mean that they need to consider using risk assets such as equities, bonds and alternatives as a better way to deliver the secure long-term income they’ll need in retirement. 

New reality #2: Your pension pot can live on long after you do

By removing the ‘death tax’ of 55% on inherited pension assets, the pensions freedoms quietly made pensions one of the most tax-efficient ways in which to pass assets from one generation to the next as they have always been free of inheritance tax (IHT).

Under the new regime, if a pension holder dies before reaching age 75, the proceeds of their pension pot can be passed tax free (subject to the lifetime allowance), while benefits passed after age 75 are taxed at the beneficiaries’ marginal rate of income tax.

This change has given a new lease of life to the estate planning market and, along with record transfer values, helped to trigger the deluge of defined benefit (DB) pension transfers we’ve seen in recent years. Such transfers present the opportunity for pension holders to enjoy similar levels of income, more tax-free cash, greater flexibility and the chance to pay less tax in retirement. They also offer the very real possibility that – with careful management – a substantial pension pot could still be available at the end of their lives to pass along to loved ones.   

This potential only increases the need for most Britons to talk through their changing requirements with their adviser to ensure their retirement stays on course.

New reality #3: How you manage the ‘big three’ risks will dictate your quality of life in your dotage

The three big risks that every adviser must help their clients to understand are:

• Longevity risk: Namely the risk that they live too long for their pension pot. To counter it, they’ll need to take a view on their likely life expectancy and ensure the level of income they take won’t erode their pension pot.
• Inflation risk: Inflation risk is the secret killer. It suddenly becomes an extremely destructive force when someone reaches retirement and stops making contributions to their pension pot.Clients need to know that if UK inflation runs at the current annual rate of 2.4%^[2] it will erode more than 20% from the value of their pension pot in the first 10 years. Scroll forward another decade and very nearly 40% of their pot will have gone in terms of real spending power.
• Sequence of return risk (or pound cost ravaging): This is the increased risk presented by a fall in returns that comes early in a client’s retirement as opposed to later down the line.This will come as news to the average UK retiree because so long as they were in the accumulation phase of their retirement planning, the order in which they got their returns never really mattered.The opposite is true for clients in decumulation; once they start taking income they effectively cement any losses which can cause irrevocable long-term damage to the value of their pension pot.

New reality #4: Sitting in cash is no longer a safe option 

Clients need to understand the role cash plays in a decumulation portfolio. For those still in the accumulation phase, cash provides a safe haven from market volatility and valuable liquidity for a portfolio. However, cash soon loses its lustre in decumulation.

This is because with interest rates so low, cash delivers a negative ‘real’ return after inflation and has done so since the early part of 2009^[3]. At current levels, UK inflation will eat about a quarter of a cash pension pot in the first decade. However, the real damage comes from using a depreciating asset like cash to fund regular income withdrawals. There is no better way to terminally deplete a pension fund.

By shunning investment risk in favour of cash, a huge swathe of Britons now risk depleting their pension pots long before their new, longer lives come to an end. Indeed, the depletion rate of a cash-only pension pot is so great that simple arithmetic would suggest most Britons in this position would be better served by buying a series of fixed-term annuities with guaranteed maturity values^[4].

New reality #5: Tomorrow won’t look much like today

Thanks to our cognitive biases, humans have a natural tendency to approach situations in the context of their recent experience. This is referred to as recency bias. This can be especially dangerous when it comes to investment for obvious reasons.

For example, right now (September 2018) the US stock market is exploring record highs as the longest bull market in its history continues to play out with its ‘trophy room’ of the world’s best-known tech names doing most of the heavy lifting. The picture is quite different in the UK and Europe, which have mostly traded sideways this year, while emerging markets actually fell into bear market territory early in September after racking up significant returns in the decade since the financial crash.

All this means that pension savers have done extremely well over the last decade – especially those who embraced risk assets. It also means that too many retirees consequently see no need to change the investment approach that served them so well while in accumulation.

Unfortunately, there’s no end of potential catalysts that could derail the current fortunes of global stock markets from President Trump’s trade war to Brexit or a host of other geopolitical issues that could suddenly come to the boil.

Any retiree who relies on their accumulation strategy to deliver on their changing income needs in retirement in the next few years is taking a huge risk. If markets change direction significantly in the next few years – which they surely must as this cycle matures – then ‘sequence of return risk’ could well cut the legs out from under their retirement.

According to our own research^[5], some 25% of those aged 45 and over have no intention of changing from their accumulation strategy to one more suited to decumulation when they reach retirement. Meanwhile, only around a third of respondents even recognise that short-term market movements are important when it comes to the value of their pension pot.  This is another obvious area where advisers can add real value.

Of course, the clock is ticking; there won’t be any prizes for those advisers who waited until markets had gone into reverse before they helped their clients to recalibrate from accumulation to decumulation.

^[1] Source: Annuity rate calculator sharingpensions.co.uk

^[2] Source: ONS as at August 2018

^[3] Source: Trading Economics

^[4] Source: Retirement Line annuity quotations

^[5] Source: The Quilter Investors 2018 Investor Sentiment Survey

'This is a Quilter Paid Post. The news and editorial staff of the Financial Times had no role in its preparation'

Important in formation

Past performance is not a guide to future performance and may not be repeated. Investment involves risk. The value of investments and the income from the m may go down as well as up and investors may not get back the amount originally invested. Because of this, an investor is not certain to make a profit on an investment and may lose money.  Exchange rates may cause the value of overseas investments to rise or fall.

This communication is issued by Quilter Investors Limited (“Quilter Investors”), Millennium Bridge House, 2 Lambeth Hill, London, England, EC4V 4AJ. Quilter Investors is authorised and regulated by the Financial Conduct Authority in the United Kingdom but is not licenced or regulated by the Monetary Authority of Singapore (“MAS”).

This communication provides information relating to certain funds known as Quilter Investors Generation CPI+3 Portfolio, Quilter Investors Generation CPI+ 4 Portfolio and Quilter Investors Generation CPI+ 5 Portfolio (the “Funds”), which are sub-funds of Quilter Investors Multi-Asset OEIC.

Quilter Investors uses all reasonable skill and care in compiling the information in this communication which is accurate only on the date of this communication. You should not rely upon the information in this communication in making investment decisions. Nothing in this communication constitutes advice or personal recommendation.

The Funds invests principally in other collective investment schemes. Your attention is drawn to the stated investment policy which is set out in the Funds’ prospectus.

Quilter Investors Multi-Asset OEIC is authorised by the Financial Conduct Authority as a non-UCITS retail scheme and can be distributed to the public in the United Kingdom. An investor should read the Key Investor Information Document(s) (“KIID”) before investing in any sub-fund of the Quilter Investors Multi-Asset OEIC. The KIID and the prospectus can be obtained from www.quilterinvestors.com in English.

The Funds are only notified as restricted schemes by MAS and are not allowed to be offered to the Singapore retail public. This marketing document shall be construed as part of an information memorandum for the purposes of section 305(5) of the Securities and Futures Act, Cap. 289 of Singapore (the "SFA"). Accordingly, this marketing document must not be relied upon or construed on its own without reference to the information memorandum. This marketing document is not a prospectus as defined in the SFA and accordingly, statutory liability under the SFA in relation to the content of prospectuses would not apply.

This document has not been registered as a prospectus by the MAS, and the offer of the shares is made pursuant to the exemptions under Sections 304 and 305 of the SFA. Accordingly, the shares may not be offered or sold, nor may the shares be the subject of an invitation for subscription or purchase, nor may this marketing document or any other document or material in connection with the offer or sale, or invitation for subscription or purchase of the shares be circulated or distributed, whether directly or indirectly, to any person in Singapore other than under exemptions provided in the SFA for offers made (a) to an institutional investor (as defined in Section 4A of the SFA) pursuant to Section 304 of the SFA, (b) to a relevant person (as defined in Section 305(5) of the SFA), or any person pursuant to an offer referred to in Section 305(2) of the SFA, and in accordance with the conditions specified in Section 305 of the SFA or (c) otherwise pursuant to, and in accordance with, the conditions of any other applicable provision of the SFA.    

Where the shares are acquired by persons who are relevant persons specified in Section 305A of the SFA, namely:

(a)  A corporation (which is not an accredited investor (as defined in Section 4A of the SFA) the sole business of which is to hold investments and the entire share capital of which is owned by one or more individuals, each of whom is an accredited investor; or

(b)  A trust (where the trustee is not an accredited investor) whose sole purpose is to hold investments and each beneficiary of the trust is an individual who is an accredited investor,

the shares, debentures and units of shares and debentures of that corporation or the beneficiaries’ rights and interest (howsoever described) in that trust shall not be transferred within 6 months after that corporation or that trust has acquired the shares pursuant to an offer made under Section 305 of the SFA except:

(1)   to an institutional investor or to a relevant person as defined in Section 305(5) of the SFA, or which arises from an offer referred to in Section 275(1A) of the SFA (in the case of that corporation) or Section 305A(3)(i)(B) of the SFA  (in the case of that trust);

(2)  Where no consideration is or will be given for the transfer;

(3)  Where the transfer is by operation of law;

(4)  As specified in Section 305A(5) of the SFA; or

(5)  As specified in Regulation 36 of the Securities and Futures (Offers of Investments) (Collective Investment Schemes) Regulations 2005 of Singapore.

QIL/ 84/18