Investors enjoy more choice than ever before about what we do with our life savings because of pensions freedom, or recent reforms to the retirement rules. There is no longer any compulsion to spend at least three quarters of your pension fund on an annuity – a form of guaranteed income for life – although it is important to remember that everyone remains free to do so with some or all of their fund.
The new freedom of choice that came into effect in April 2015, for everyone aged 55 or older, raises important questions that are difficult to answer. How much is enough? How long have you got? What income might be sustainable for the rest of your life? What are your individual and family priorities for financial planning, including possible transfers between generations?
These are just four of the areas of uncertainty that can confront people considering giving up some or all of the guarantees that only an annuity can provide, in favour of investing to fund retirement through what is known as income drawdown. Other issues that cannot be predicted with certainty include future rates of investment return and inflation.
Identifying the best way to enjoy our life savings in retirement will probably be among the most important financial decisions we ever make. Unlike people who are still at work, it might be impossible to make good any mistakes or financial losses by putting in overtime or striving harder for a bonus.
‘It is vital to ensure our savings do not expire before we do.’
For this reason, it is sometimes said that pensioners are investing irreplaceable capital. While few of us aim to be the richest person in the graveyard, most might agree that it is vital to ensure our savings do not expire before we do and many may aspire to make use of the ability to leave income drawdown funds as a tax-free inheritance.
So it makes sense to consider taking professional advice to help with such important decisions and to monitor progress as they are put into practice. For example, everyone aged 55 or over is still entitled to take 25% of their pension fund as a tax-free lump sum but any withdrawals beyond that may be liable to income tax in the usual way.
This raises the risk that people who draw too much out of their funds too soon may pay more tax than they need to. For example, during the fiscal year that will end on April 5, 2018, anyone who draws more than £33,500 out of their pension could be liable to 40% tax, assuming they have already utilised their 25% tax-free lump sum withdrawal and their personal allowance of £11,500; the threshold for income tax. The age allowance was abolished in 2016.
On the same basis, people who withdraw more than £150,000 from their pension – perhaps to buy a holiday home or to fund property purchase for adult children – may be liable to 45% income tax.
No wonder the chief City regulator, the Financial Conduct Authority (FCA), has expressed concern that ill-advised or unadvised use of pensions freedom may result in HM Revenue & Customs (HMRC) taking too big a share of some income drawdown funds.
The FCA Retirement Outcomes report said more than half – or 53% – of pension funds accessed under the new freedom of choice had been fully withdrawn and the cash from half these fully-withdrawn pensions had been moved into other savings or investments. The FCA report said: “This can result in consumers paying too much tax, missing out on investment growth or losing out on other benefits.”
‘A diversified portfolio can diminish the risk inherent in stock markets by spreading your wealth over a wide range of underlying investments.’
Pensioners, including those using income drawdown, have access to the same tax shelters as other adults and it makes sense to consider utilising annual allowances for individual savings accounts (ISAs) and other opportunities to keep HMRC’s share of your wealth to a minimum. For example, during the current fiscal year, any adult can shelter up to £20,000 in an ISA to render income and gains tax-free.
However, it is important to remember this allowance is annual. This means it expires on April 5 each year and you cannot go back to make use of unutilised allowances from earlier years. So, with annual allowances, it really is a case of use them or lose them.
Tax is deducted from dividends at source and cannot be reclaimed but there is no further liability to tax on any income or gains withdrawn from ISAs at any time. Pensioners can also benefit from the personal savings allowance, which enables basic rate taxpayers to receive up to £1,000 of interest on bank or building society deposits tax-free.
Higher rate taxpayers can receive up to £500 tax-free interest this way. Similarly, pensioners are also entitled to receive up to £5,000 tax-free dividends from shares and share-based funds by means of the annual dividend allowance.
‘Professional financial advisers can help you construct diversified portfolios that might include uncorrelated assets – so their prices do not all fall or rise at the same time but tend to balance each other.’
Most importantly, anyone considering income drawdown must beware of the risk that stock markets can fall without warning and you may get back less than you invest. For example, the FTSE 100 index of Britain’s biggest shares has fallen by nearly 50% twice so far this century – hitting low points in 2003 and 2009 – so it is vital to think carefully about how you might be affected if this were to happen again.
A diversified portfolio can diminish the risk inherent in stock markets by spreading your wealth over a wide range of underlying investments to reduce your exposure to setbacks or failure at any one company, sector or country. Professional financial advisers can help you construct diversified portfolios that might include uncorrelated assets – so their prices do not all fall or rise at the same time but tend to balance each other – and monitor their progress regularly through your retirement.
Another issue to consider is ‘sequence risk’ or the mathematical fact that the value of your fund will be affected by the order in which gains and losses occur. For example, consider two investors who each retire with £100,000 and both enjoy average annual returns of 7% and draw annual income of £7,000 over the next decade.
‘Unfortunate Francis’ suffers losses in the early years and gets his gains later, while ‘Lucky Louise’ experiences the same returns the other way round. As a result, despite having the exact same annual average return over this decade, Louise ends up with a fund worth more than £120,000 while Francis has less than £72,000.
The explanation is the way percentages work; if you lose 20% one year, you need to gain 25% to get back to where you started. Or, if markets fall by 50%, you would need a 100% rebound to recover fully. So it makes sense to build as big a fund as you can before retirement, so that you are able to afford to consider the potential risks and rewards of the new choices created by pensions freedom.
Similarly, given the importance of these decisions, it makes sense to consider professional advice to plan for a safe and sustainable income, so that you can enjoy your pension and retirement really does become the holiday of a lifetime.