Given the well-documented increases in the cost of living, some clients may be looking to withdraw money from their pensions to top up their existing income.
This could be a reasonable, or indeed the only, option for some but advisers should be asking some hard questions before they recommend this course of action.
Do they really need to spend more?
Most people hate to accept a downturn in their lifestyle and will often strenuously oppose the idea that they could do without some of the things that support it.
The inescapable fact is that spending more now almost certainly means spending less later. It is true that some items mean more to some people than others; a holiday may simply be a chance to have fun for some, while for someone spending their last days with a terminally ill spouse it could mean everything.
Clients will always have a reason they believe they cannot spend less, but in order to do their job advisers must at the very least question if their current expenditure is really necessary.
The inescapable fact is that spending more now almost certainly means spending less later.
Is the situation likely to get better soon enough to make up for the additional spending?
Many clients have received very strong investment returns in recent years and it may be tempting for them to assume that future returns will restore their fund values even after more money has been withdrawn.
This is a plausible argument. However, even if these returns are maintained, increased spending will result in greater depletion and sadly most commentators do not believe that returns will continue as before.
We also do not know how long inflated prices will continue to apply and when, or if, clients’ spending will return to previous levels.
In addition, advisers must consider the impact of sequencing risk, so-called ‘pound cost ravaging’.
Advisers should show the client the impact of increased spending and ask them to look at an alternative ‘what if I spend less’ scenario.A fund value that is reduced in value now will have to work much harder in future. Even if returns improve the return will be made on a smaller fund and it may never catch up with the overall growth it might have achieved.
Clients who have already survived a few years of income drawdown will have built up larger funds, but may still need to be persuaded to give up unnecessary expenditure to ensure they can maintain their lifestyle in the long term.
Advisers who use cash flow modelling should show the client the impact of increased spending and ask them to look at an alternative ‘what if I spend less’ scenario, with specific focus on longevity and income sustainability.
Offsetting increased energy bills by reducing other expenditure, if possible, will almost certainly deliver a better result.
What other options do they have?
It is not uncommon for clients who have reached pension age to look at their pension first when in need of more income.
This is not surprising. After all, the main purpose of a pension is to provide income in retirement, however advisers are aware that this it is not always the most efficient route.
Clients often appear to have a more emotional attachment to their Isas, cash and rental portfolios than their pension – the result perhaps of having very little to do with it while it was unavailable for access.
Persuading a client to spend their Isas, cash and other assets may come down to the adviser’s ability to carry out often complicated tax calculations and to explain the results in a way that the client can relate to.
Once a client has reached age 55 Isas should be more of a current account while any pensions not required to produce income take over as the back-up plan.Starting with any remaining pension commencement lump sum makes sense, although of course it will reduce the value of the future investment, but anything beyond this tax-free cash amount will be subject to income tax.
Clients should also be made aware that drawing taxable income will also impact on their ability to save more into their pension, and that the faster money is withdrawn the greater the cumulative tax bill is likely to be with the impact being greatest for those who take income when accessing their pension for the first time.
HM Revenue & Customs has still not seen fit to alter the position with regard to emergency tax on these payments and clients very often get a shock when they see how much has been deducted.
The excess can of course be reclaimed, but this will not help if the client has a pressing bill to pay immediately.
After tax-free cash the next most obvious encashment should be any Isas as these may be paid free of tax.
Often seen as a ‘rainy day’ fund during the pension accumulation years, once a client has reached age 55 Isas should be more of a current account while any pensions not required to produce income take over as the back-up plan.
We would also recommend using the client’s capital allowances, either to fund increased spending or to replace withdrawals taken from pension or Isas.
Is there any upside to the current situation?
For many people, finances will be more difficult this year.
Advised clients, who for obvious reasons tend to have greater assets than the average population, are likely to be less affected and there is one area where the rising cost of living could actually be helpful.
Since the introduction of pension freedoms in 2015 annuity sales have plummeted, partly because rates have been at their lowest level for some time.
I am far from suggesting that annuity purchase should be all about rates, but for those whom an annuity would actually suit their circumstances the prospect of improving rates when prices rise could be attractive.
There are many clients who have been in drawdown for some time now and who would like to reduce their exposure to investment risk in exchange for some security against longevity risk
These clients may well benefit from another look at full or partial annuitisation in the next few months.
Fiona Tait is technical director at Intelligent Pensions
