A “Third Way” for UK Pensions and QROPS
"Third Way" - An Introduction:
This is an explanatory document about the evolution of Pensions in the UK now encompassing the benefits of globalisation, guarantees and Qualifying Recognised Overseas Pension Schemes (QROPS).
The Third Way looks at solutions to the volatility in investment markets and what appear to be long term low interest rates. These factors are beyond the control of individual investors but that have a huge impact on the willingness of individuals to make provision for retirement.
The recent credit crisis has hugely damaged Pensions and Pensioners. Long held assumptions relating to pensions seem to have been swept away. The stock market’s volatility has resulted in pensions significantly dropping in value. The FTSE 100 index is still more than 20% lower than its peak in December 1999. The Bank of England have printed money to buy gilts, employers are cutting contributions - often substantially - to employee pension schemes and annuity rates have plummeted. The timing of this could not have been worse.
The baby boomers are reaching state pension age around now and are about to retire. However, they did not have as many children as previous generations – fertility rates fell sharply in the 1970s causing the proportion of workers to pensioners in the population to fall dramatically. This means that there quite simply may not be enough taxpayers to pay their pensions.
In 1941 there were 5.6 workers for each pensioner; in 2000 there were barely 4 workers for each pensioner and by 2040 there will be just 2.6. As pensioners are generally living longer, the costs are rising. This is a huge burden on the future taxpayers, as a much larger number of pensioners will need to be funded by a much smaller number of taxpayers.
The long term implications of the global economic situation will have implications perhaps for generations making it ever more essential for individuals to achieve financial security but how is this achieved in the pressurised vacuum of modern life
What are pensions?
There are two major elements to pensions.
- Social welfare support (the original intent of a state pension.)
- Private long-term savings, in which people save money while they are working to give them a comfortable standard of living later in life.
The government has the most significant role in social welfare. Employers took on some of that responsibility, when some set up final salary pension schemes to support their workers in retirement. These schemes offered benefits very similar to social welfare with employers promising to pay pensions for the duration of workers retirement.
The result of this was that successive UK Governments were able to reduce the state pension expecting employer pensions to make up for state cuts. With life expectancy consistently increasing, regulatory burdens and liabilities increasing and volatile investments, employers cannot offer the same pension guarantees and many have even closed the current schemes to any further benefits.
Final salary pensions were providing a significant chunk of workers long-term savings for retirement as their employers would pay into these schemes for workers that often had little or no other savings. The final salary schemes are being replaced by employers with far less generous and more risky money purchase pension plans, placing increased burdens on individuals to provide for their own retirement. Employers have been rapidly reducing their pension contributions too. The credit crisis has made the situation dramatically worse.
As employers and the Government are consistently making cut backs, individuals are finding they have to do increasingly more for themselves.
Why is this happening?
The UK state pension is so low that individuals really need other private income as a means to avoid poverty but unfortunately pensions are not producing the necessary incomes for many people. Significant damage has been caused by the extreme volatility in the stock market. For example, PwC (PriceWaterhouseCoopers) recently calculated that defined contribution pension investors have lost 3% a year, each year for the last 10 years.
The FTSE 100 index reflects this. At its peak in December 1999 it stood at 6950. In December 2009 it hovers around the 5300 mark a fall of over 20%. This is not even near its largest fall range differential over the last 10 years. Final salary employer schemes delivered quite well for the current generation, but the cost and risk factors of these to employers has proved too high to bear. Many employers citing that continued liability to the pension scheme could see them go into administration.
The Pension ‘tail wagging the dog’!
Apart from the public sector, there is now little or no final salary or other defined benefit pension schemes available. People are now increasingly on their own and have to accept that they have far more responsibility than previous generations in providing for their retirement income.
But what is the objective of pension savings:
- To deliver security in retirement?
- Or to maximise potential returns on the pension savings?
It is not easy planning for retirement and pensions; it is however vital if people are to avoid long-term poverty in old age. These questions highlight two vital elements. There is importance in separating the idea of:
- Building up a ‘pension fund’
- Receiving ‘pension income’.
There is often confusion as the accumulated pension ‘fund’ is also referred to as the ‘pension’ even though this is incorrect. A large number of people believe they are putting savings into a ‘pension’ and policymakers often refer to them as having a ‘pension’ but the reality is that putting money into a pension fund is not the same as receiving a ‘pension’ out of it.
There are risks and challenges in both elements. Millions of people have been left facing an impoverished old age because of the idea that the stock markets can be relied upon to deliver long-term strong returns. Achieving a measure of security in old age is a goal for a large proportion of people – they are not so worried about maximising investment returns. In light of the current crisis and upheavals in the pension market, perhaps new approaches to pension planning are needed.
Has it gone wrong?
UK pension policy was often said to provide a model to the rest of the world. The idea of having a very low state pension, supplemented with good employer or personal pensions, with pension contributions invested mainly in the stock market to produce strong growth, was seen as a good one. The expectation of this was to ensure the affordability of supporting an ageing population. Long-term equity investments would deliver strong returns to pay generous pensions in retirement. To put it into context, the UK pension system has been based on a gamble that equities were reliable enough to deliver good pensions over the long term. Equities were relied upon by the generous final salary pension schemes, as were forecasts for good personal pensions. These both relied upon the equity bet paying off and these expected strong equity returns enabled successive Governments to cut UK state pensions over time.
Stock market investing = good private pensions!
The equity pensions started in the 1960’s in the UK company schemes and was later imported into personal pensions in the 1980’s. Forecasts from the Government consistently showed that the costs of supporting the massive rise in the number of pensioners would remain low, as rising private pensions would benefit by means of the stock market, offset falling state payments and leave retirees with a good income maintaining their standard of living. The idea for UK pensions was that workers would be well looked after by either their employer or by their investment managers who would invest their money in equities in order to deliver long term strong returns. Policymakers never seriously considered that equities might fail to deliver over the long term, and due to this, workers were never fully explained to that this whole policy entailed significant risks and that they were gambling their future security on the stock market. Many pension plans have been devastated by falling pension fund values due to the collapse of the stock market. Therefore the risk of poverty for the UK’s rapidly ageing population has greatly increased.
Employer pension provision in decline
Going forward, workers from the private sector can no longer rely on final salary schemes. To a certain degree, the workers are ‘on their own’. Employers are now contributing far lower percentages of salary as they are now opting for money purchase schemes (or defined contribution schemes). Final salary schemes generally require contributions of more than 20% of each workers salary whereas the average contribution to money purchase schemes is less than 10%. There has been evidence in recent months that employers are actually cutting contributions further in response to the credit crisis. The less employers pay into their workers pension funds, the lower the future pension taken out is likely to be. This trend is expected to continue for employers, especially when the Governments new ‘personal accounts’ pension scheme is introduced which will require only 3% employer contributions. As both state and employer pension provision decline, the importance of individual long-term savings increases. The less employers help, people will increasingly be on their own to cope with both the costs and the risks.
Relying on risky equities
It was said to be evident that if investors took more risk by investing in the stock market, that this risk would be rewarded in the long-term. Every single equity investor was led to believe that even if the markets were volatile in the short-term, they would be rewarded in the longer term as their equity investments would deliver strong returns higher than deposit based funds and government bonds. They believed that they would all benefit from the ‘equity risk premium’. This interpretation of equities may have been incorrect. Financial theory suggests that on average, over the long term, equities should perform better than risk free bonds. However, this does only apply on average, so some will benefit and some won’t benefit from the risk premium. It only applies ‘over the long term’ but we do not know how long that term is. Some will win but many will lose. Policy did not factor in the possibility of equities not outperforming gilts; therefore there has been no planning by either the Government or employers for the inadequate level of private pensions that people are currently encountering. The fact is that theory doesn’t actually tell us anything about whether a certain investor or fund which decides to take the investment risk of investing in equities, will actually achieve higher returns than investing in risk free bonds. It also does not set out any kind of timescale it may take any such out performance to occur. This means that investors can’t rely on equity investments to deliver stronger returns than bonds. IMPORTANT NOTE: For instance, the Japanese stock market is still only 20% of the size that is was 20 years ago and shows no signs of recovering. In the UK, bonds have outperformed equities for 10 years.
The risks and costs of private pension provision
The risks and costs taken on by employers with their final salary pension salary schemes was huge – by offering to pay a specific level of pension to their employees when they retired no matter how long they lived for. It is not just the level of cost that has caused problems for employers in recent years, but also the actual uncertainty of that cost. It was hard for employers to determine how long workers would live for, what assets would give the best returns and what would happen to future salaries. The credit crisis has bought these uncertainties into stark relief, during which deficits have increased dramatically, assets have fallen and liabilities have increased. Employer schemes had little or no protection against falling equity markets, rising life expectancy or falling interest rates which have led to massive funding problems for them. Some companies for example British Airways (Dec 2009) now have pension deficits (assets vs. liabilities) greater than the market capitalisation of the company that runs them. As the CEO of a budget airline once quipped: British Airways is a Pension fund that happens to run an airline. It was a perception from employers that they did not need any protection as they expected stock market returns would be large enough to cover all these obstacles and continue to pay out good pensions. This optimism has not been beneficial as employers attempt to reduce their exposure to pension commitments; this leaves the workers in a far more exposed position. Many individuals now face all of the risks and costs themselves as they no longer have final salary or defined benefit pension schemes. This is why it is important that people understand exactly what the risks and costs are that their employers have now passed to them. Looking at the risks that employers faced with a final salary pension scheme gives us an idea of the risks that individuals will increasingly be facing. These include:
- Investment risk
- Manager risk
- Longevity risk
- Inflation risk
- Interest rate risk
- Regulation risk
Investment risk is higher, the more risky the assets invested in. People are encouraged to think about potential returns and risks when choosing which assets to invest in for the long term. The problem is that not enough attention gets paid to the risk element of these decisions. For the people who chose to invest in the stock market over the last 10 years, the value of their investments will actually be lower than if they had chosen an investment with no risk at all.
Manager risk compounds investment risk. Even if the right asset classes are chosen to invest in, if poor active managers are selected then there is a risk of the investment not performing well. If a passive manager rather than an active manager is chosen then this manager risk can be mostly overcome. This manager selection should ensure that the trends are captured in the chosen assets, without too much risk of underperformance.
Longevity risk has proven itself a substantial problem for pension investors. Life expectance has increased dramatically more than has been previously forecast, rising approximately 1 year in every 4 years. Due to this, the cost of paying pensions rises significantly as payments need to be made for a greater number of years than they previously did. However, this also means that pensions may have to last for many more years than they would have been expected to in the past. The result of this will be the increased cost of providing pension and there are no simple ways to protect against this risk
Inflation risk has been a particular issue for final salary pension schemes. As future pensions will be related to future salary prior to retirement, final salary scheme employers were exposed to the risk that wages could rise at a faster rate than prices. Also, when pensions start to be paid they are often expected to increase with price inflation. Index linked bonds are the best way to get some form of protection against rising price inflation, however it is very difficult to hedge salary inflation risks
Interest rate risk can be problematic for final salary pension schemes. This is because the employer must ensure that certain levels of pension promises are properly provided for. The lower that interest rates fall, the more money the employer has to put into the pension to cover the future pension payments, since he would be expected to earn lower rates of return over time on the find’s assets. As individuals get close to retirement, interest rate risk is most relevant, as the cost of buying an annuity will be linked to the level of interest rates. Annuities are more expensive if rates are lower.
Regulation risk was also a particular problem for final salary pension schemes; this is because Governments kept adding extra burdens and requirements onto employers over the years, all of which kept making the pension provision more expensive. This risk in particular should not be as problematic for investors in private pensions, but the current requirement to purchase an annuity by the time you are 75 years old could cause difficulties in the future. Employer final salary schemes additionally took care of the costs of pension provision, so workers did not necessarily have to worry about these directly either. The costs include:
- Investment managements costs
- Cost of investment advice and manager selection
- Cost of setting up and running the pension fund and collecting contributions
- Cost of actuarial advice
- Cost of administering pension payments
Whether it is directly or indirectly, individuals will shoulder all these costs themselves if responsible for their own private pension. Investment management costs, investment advice and administration can take more than 2% a year out of a pension fund.
Are people aware and prepared?
The majority of people do not properly consider all of the risks and costs involved in planning for their pensions. The actual difficulty for people to save for their retirement has been massively underestimated by both policymakers and individuals themselves. In reality it is not only the employer final salary schemes that are in trouble. Almost all of the money purchase schemes, whether they are organised privately or by employers, have suffered. A large number of people have found that their pension fund values have fallen drastically in recent months and years, leaving their retirement plans in need of being reviewed. A 25 year old earning £25,000 a year, who contributes 10% of his salary into a pension, has seen his projected pension at age 65 fall by 36% during the credit crisis. In September 2007, he would have projected to retire with a pension of approximately £17,000 a year, however, due to lower annuity rates and the falling markets, his expected pension at age 65 has now fallen to under £11,000 a year. If people are unable to rely on the state and their employer to provide much pension income, people face large challenges and may want to protect themselves better in future.
The future – what now?
When people originally invested in their private pensions, the idea that equity might underperform gilts for decades was never factored into forecasts. If it can not be assumed that the stock markets will deliver high long-term, reliable returns for decent pension, then it may be the case that a new approach to saving and retirement planning will be called for. Individuals will have to take much more responsibility for both building up a pension fund and then taking out the pension income from that fund. The reality is that as life expectancy keeps increasing, pension planning is likely to comprise of some combination of longer working lives, higher savings, better protection and more flexibility than we are used with. This conclusion was clearly shown in the results of two surveys just carried out by MetLife.
What has happened as a result of the current economic climate? Two nationwide surveys to ask people about their attitudes to long-term investment and found:
- The first of these surveys was of those closest to retirement age – age 55-64 – and asked how they had been influenced by the credit crisis.
- The second of these surveys covered all age groups and asked about their retirement plans and how their views have been altered in light of recent events.
The results of these two surveys showed that the credit crisis has damaged nationwide confidence in the benefits over the long-term of investing in equities. It has also left people nearing retirement disappointed with their pensions and needing to continue working to afford the lifestyles they want. The heavy reliance that people have placed on their stock market investments has been a disappointment to those nearing retirements and a significant minority wishes they had never bothered with pensions at all. A summary of the results is as follows:
Survey of people age 55-64: Those closest to retirement disappointed with pensions and need to keep working:
- Over half (54%) of these people said that their pensions would fall short of their expectations and were concerned that they will not get a good income.
- A third of people felt that their money had been wasted and wish that they had not bothered or were not pleased that they had done so.
- Just 4% of the respondents said that they were pleased with their pension and expected it to give them a good income.
- A huge 56% said that they would now continue working in retirement, either full or part time.
- Less than 33% said that they would will definitely not work.
Survey of all ages: Credit crisis has knocked confidence in stock market:
- 50% of all respondents said that they were not confident and only 1% said that they were very confident that long-term equity investment would deliver good retirement income.
- 66% are less confident in the stock market because of the credit crisis and only 9% believed the stock market was a sound long term investment, this suggests that recent events have dented faith in equities.
Survey of all ages: Interest in insuring against stock market losses:
- 43% of people said that they would like the idea of being able to pay some insurance against losing money in the stock market and that this would make them more confident.
For some older people, remaining in work may not be a problem and it is possible that some may even welcome this. However, it seems that the coming generation is being forced to stay at work because they can no longer rely on private pensions, even if conventional advice has been followed to invest for the long term and they have been willing to take investment risk and set money aside for their retirement. The reality is that we may need to re-asses out attitudes to pension planning, longer term investments and later life income. One other survey found that rather tongue in cheek; the British attitude toward savings was now winning the lottery!
A new approach to pension planning
We have looked at the two very distinct elements of pensions – accumulating a pension fund and taking a pension income from that fund. Having a pension fund and getting a good pension income is not the same thing. Both parts are important to your future security and you need to understand them, and then maybe consider ways to plan more securely for both.
Building up a ‘pension fund’
The value of your ‘pension fund’ when you reach the age at which you need to start living on some income from the fund, will depend on:
- The contributions paid over the years
- The charges paid to whoever provides or manages the pension fund
- What assets the money has been invested in
- How those chosen investments perform
Obviously the investments perform better if you put more money in, and the charges become lower. Over time this all results in a greater sum of money built up in the pension fund. A key factor in accumulating a good pension fund is deciding on the right mix of contributions, investments and charges.
Traditional financial planning:
People trying to build up a good pension fund were, in the past, given two main choices:
- Opt for more investment risk in order to chase higher potential returns in the stock market. This was expected to be rewarded in the long term and everyone was led to believe they could rely more on later life income with lower contributions.
- Choose lower risk, lower potential return investments, which will deliver slow, steady growth. However, this option would probably need much higher contributions to deliver an acceptable later life income.
Another ‘Third’ way:
In recent times a ‘third option’ or ‘third way’ has been developed – a ‘protected’ approach which offers protection against falling stock markets by using what are known as ‘unit-linked guarantees’. These are not to be confused with structured products the like of which the failed Lehman Brothers was a major contributor. These guarantees have proved popular in both Japan and the US and are now building market share in the UK. There is a possibility that they will increasingly become a part of mainstream retirement planning, as unstable market conditions increase the attractions of guarantees. This new approach makes it possible to try to achieve higher potential returns from stock markets, but at the same time protect against large losses. If you have plenty of other secure income for your retirement, you may not need to worry about whether or not your pension does well, however if you do not have much else to rely on then you may be attracted to the idea of protection. These guarantees should give a return - on average – above the returns on risk free assets (UK Government gilts) and below those of equities without any protection, however, you will still have the opportunity to benefit from strong markets – while simultaneously insuring yourself against the loss of money if the markets do not do well. Of course, the very sharp falls suffered by equity markets in recent months may have led you to think that equities have significant upside potential. If you are convinced that the stock market has to go up and cannot fall much, then you may feel confident enough to take the risk and wait for it to work for you. However, if you are not totally sure or simply cannot afford to get it wrong, then you may want to consider third way solutions. In reality, there are no guarantees that the stock market will rise strongly. If the economy fails to recover, or the UK experiences a repeat of the Japanese experience, there could also be much more downside risk even from current levels. This means that you may be partial to keeping your money in the stock market, but you may also consider these protected products.
Protecting your UK or Overseas Pension fund (QROPS)
If you protect your pension fund, you will be covered against losing money in the stock market. This would allow you to invest in equities, and that would give you the opportunity to benefit from rising markets over time – it would also mean that you would not end up with less than you have invested over the years. Taking out this kind of protection could also allow you to lock-in gains periodically after a market rise. Example:
- You have a pension fund of £50,000 today, and then the protection would guarantee that the value of your fund would not fall below £50,000 in the future.
- If after a period of time, the value of your investment had risen by 20% to £60,000, then protection could lock in that gain.
- This would then mean that your fund would not fall in value below £60,000 in the future.
- Even if the markets then fall back over the next few years, the minimum value of your pension fund would be £60,000 and at least that value would be guaranteed by the provider whenever you retire.
Until you decided to start taking a pension income from your fund, this process would be repeated periodically. If your fund value had increased as investments performed well, the new higher value will be protected, however, if the investments performed badly, the fund value would remain protected and therefore would not fall.
Building up a ‘pension fund’
You will need to think about taking an income from your pension fund once you reach retirement age. You may wish to wait to take income or you may prefer to take it immediately. There are different options open to you on retirement and the choice is not always simple. Over 60% of people will consider living and retiring abroad. In our mobile society very few take into account where they might ultimately retire and the tax implications of such a move. Interestingly the ‘place in the sun’ destinations such as Spain, Portugal and Cyprus have particularly advantageous tax regimes for pension income paying much lower income tax. Cyprus for example levies a 5% income tax after personal allowances on Pension income for residents. Spain and Portugal whilst more complex, the income tax liability can be even less than Cyprus.
25% Lump sum
It is important to know that UK Pension legislation and many overseas pension arrangements (QROPS) allows for you to take up to 25% of your pension fund as a lump sum. This money can be taken and spent as you wish. You may also decide that you will live on it for a while and leave the remainder of your pension invested in the markets, hoping to benefit from good returns in the future. This would obviously mean that you would still be at risk of falling markets on what is left of your pension fund whether in the UK or a QROPS. People are keen to know how much pension they will receive in the future, however the amount of pension income you will get from your pension fund is not easy to predict in advance. Many factors can affect it and you will have a number of possible choices to make, which will affect your pension income. For everyone who has a private pension fund, it is important to understand what options are available for taking a pension income out of it. Until recently, Pension legislation dictated that all of the money that had been accumulated in a money purchase pension fund (excluding the initial tax free cash lump sum) must be converted into a lifetime, lifelong income by age 75 at the latest. For UK residents if this is not done then there are significant tax penalties. BUT the emergence of overseas pensions (QROPS) allows people who live and or retire abroad the ultimate prize of passing 100% of the pension fund to beneficiaries on death without any UK tax implications.. Overseas pensions (QROPS) for large and small pension funds are proving to be a revelation in removing the single largest objection to pension funding , that being death benefits are lost in tax or to an insurance company providing an annuity. The most common way today of converting a pension fund into pension income is to purchase an annuity. The annuity is therefore more than likely what most people think of as their ‘pension’. Over 450,000 annuities were bought last year with a value of around £11 billion; however a large number of people may not realise the potential pitfalls. People may also not know about the alternative options available to them, Datamoniter figures show that 90% of retirees simply purchase the fixed annuity that is offered to them by their pension company and 40% of them do not even consider any alternative options. I don’t want to buy an annuity! In the last few years, the Government has introduced more flexible options to take income from your accumulated pension fund. Even though the majority of people simply choose a fixed lifetime annuity, there are now more options available. What products are available at retirement to provide pension income?
- Fixed rate lifetime annuity
- Inflation-linked or escalating lifetime annuity
- With-profits (investment-based) lifetime annuity
- Income drawdown (unsecured pension )
- Overseas Pensions and Qualifying Recognised Overseas Pension Schemes (QROPS)
- Unit-linked guarantees
The complexity is increased by having more choice. This may make it harder for you to weigh up your options and make sensible choices for your future. The most sensible thing to do would be to seek independent financial advice. It is extremely important to make the correct choice. By the time you are age 60, you may well still have over 30 years of life ahead of you. It will be important to you to use your pension savings as well as you can in order to help you fund your retirement, without ending up in poverty or running out of money. You may also need to ensure that you do not lock into an annuity rate at the worst time without any chance to benefit from better rates or a higher value pension fund in the future.
Credit crisis and pension annuities.
The credit crisis has led to a significant drop in interest rates as well as causing the value of most people’s pension funds to drop. As the Bank of England prints money in order to purchase corporate bonds and gilts, in pursuit of its policy of quantitative easing, it is pushing interest rates down further which leads to a lower annuity pension income for anyone purchasing an annuity now. Due to annuities being such an inflexible product, deciding to convert your pension fund into an annuity at the moment could be a very bad time for you. If markets do recover, your pension fund will have been given away to the insurance company and you would not be able to benefit from higher asset prices. If interest rates rise again, then you will also not be able to benefit from better annuity prices in the future either. As a result many people may wish to consider alternative options.
Alternatives for taking pension income out of your pension fund?
There are various factors that will determine the amount of pension income that you receive from you pension fund and these are very different from the factors that influence the size of the pension fund itself. The income will depend on:
- Whether you choose income drawdown (unsecured pension) for a period instead of buying an annuity.
- Where you will be resident when retiring – UK or abroad.
- The charges levied on annuity purchase or income drawdown (unsecured pension or QROPS).
- The performance of any investments held in drawdown.
- Investment risk.
- If and when you buy annuity.
- The type of annuity purchased e.g. index-linked, with profits, fixed.
- How much tax-free cash you take out of the fund.
- Whether any insurance is taken out to protect capital and/or provide minimum income.
- The cost of any insurance taken out.
With-profits annuities began in the 1990’s in order to help people participate in the potential returns of higher risk and higher expected return investments than bonds. They offer some form of protection against falling markets by promising to smooth the investment returns over time. They can be quite inflexible and complex as you would have to choose an initial level of income. This is determined by what is known as the ‘Anticipated Bonus Rate’ (ABR) which varies from around 1% to 4%, with higher ABR offering higher starting income, however this income will fall if the with profits investment fund falls. Often, these annuities offer a guaranteed minimum investment level (ABR 0%) but this income would much lower than available on other products. Also, if you die soon after taking the annuity, your entire pension fund is lost and therefore none can be passed on to your survivors. This can indeed offer some protection against the worst of the falls in the market; however you are still at the mercy of the investment manager risk if the with-profits fund performs poorly.
Income drawdown - now called unsecured pension or QROPS
In recent times, increasing numbers of retirees were attracted to delaying annuitising when they initially retired. They were encouraged to leave their funds invested for a few more years in ‘income drawdown’ in the hope of being able to benefit from market performance. Income drawdown is the name given to a product which would allow you to continue to keep your retirement savings invested and take an income each year rather than buying an annuity. This facility can continue for the duration of life, although the tax level payable for UK residents on unused funds on death is prohibitive beyond the age of 75 years old, so many people decide to buy an annuity at that age. The income that is available to be taken from a drawdown arrangement can be varied each year between a minimum and maximum set out by the Government Actuary’s Department. QROPS have no such death tax restrictions for individuals who reside abroad and complete 5 years of non UK residency. The illustrations of expected investment returns that were approved by the FSA (Financial services Authority) flattered income drawdown due to the fact that they did not have to show what could happen when markets collapse or stay low for numerous years, similar to what has happened in the past 20 years in Japan. Unfortunately, the majority of people that bought a drawdown policy in the last few years would have done better to have either taken out insurance guarantees or to have purchased an annuity instead. Some drawdown investors risk running out of money before they die due to the high charges and poor investment returns. This is partially because a large number of their investments were left in the stock market, without any downside protection and they have therefore lost significant amounts of capital.
Protection against investment losses
Pension and investment bonds with explicit guarantees are now available to purchase as a form of protection against falling investment values. With such products, you know that you will al least achieve a minimum return. You would hope to do considerably better than this minimum, but at least retirement can assume some minimum underpin, even if investment markets prove disappointing. This form of protection has become very popular in both Asia and the US; this approach is beginning to become more prevalent in the UK. Between 2007 and 2008, Watson Wyatt figures have shown that the sales of unit-linked guarantees doubled, rising from £539 million to £1.1 billion. Due to the recent stock market experience, it seems likely that such an approach to protection will heighten. If you do not want to lock in to today’s annuity rates, if you wish to have the option of benefiting from higher investment markets and higher interest rates in the future you could consider taking your tax-free cash straight away and then buying an insured income for the future. This would not be allowed to fall below the minimum insured level in the future. However, this income could grow over time if the investment markets do well for you. Protecting your pension income allows you to insure against the income from your pension fund in the future falling below a minimum level. The provider will promise to pay you at least a certain amount every year until you die. If you investments perform well, the income you receive may go up over time, however if the investments perform badly then your income is still fixed at that minimum level. What are the benefits of protection?
- More flexible than conventional annuity, less risky than income drawdown.
- Still benefit from market upturns, but don’t suffer losses.
- Peace of mind – easier to plan because you know your minimum income.
- Death benefit – if you die young, your pension fund is not wasted.
What are the downsides of protection?
- The cost will limit the upside if the markets do very well.
- The value of your pension fund will be less than it could be without the protection.
- Less control over the underlying investment assets.
- Charges – there is a cost for the guarantee.
The protection provider could go bust – which means you should;
- Try to ensure that the provider is financially strong enough to survive extreme market conditions.
- Confirm what other consumer protection is in place like the UK Financial Services Compensation Scheme (FSCS).
Investment risk before retirement There are several issues that need to be considered when building up a long-term fund for pension income.
- What contributions can I afford?
- Should I invest in the stock market and hope that I will get high returns by taking the risk? – will the equity risk premium help me and will it deliver returns in time?
- Should I invest in safer bonds, which will not deliver much return, but at least I should be better able to know what my fund will be worth?
- Can I afford to be hit by prolonged periods of steep decline in the stock market?
- Am I willing to pay a premium to insure my fund against sharp falls in stock markets?
At retirement planning For people nearing retirement, there are several important issues to understand and choices that need to be made in order to try to provide pension income. These questions include:
- Do I have significant other assets so that my pension fund is not crucial to my standard of living?
- What kind of annuity do I want – can I be sure of my needs over a 20 or 30 year retirement?
- Can I expect to live longer or shorter than average? Am I in good health, or do I have some serious illnesses or family hereditary concerns?
- Is now a good time to convert my pension savings into an annuity?
- If not, should I just take my 25% tax-free cash lump sum out now and leave the rest of my pension money invested to hope to grow more?
- Do I need to have protection against inflation?
- Can I insure myself against falling markets?
Anyone who does not lock into a lifetime annuity on retirement will possibly need to keep making decisions each year about their pension fund and their future income. They will still potentially be exposed to market risks but will also have the possibility of extra returns and higher pension income if the pension fund keeps growing.
Choices each year:
- Do I buy an annuity now – is this a good time, or might rates improve if I wait?
- What investments should my fund be in now?
So what do you need to do now? The vital questions
- Are you able to assume that a pure equities strategy will work for you over the ‘long term’?
- Is gambling on the stock market the best way to save for retirement?
- Are you able to afford to find that you are left with little more than a state pension?
- Would you be willing to pay for some protection to help you have a solid minimum base of private retirement income?
These are vital questions which people need to consider now.
Unrecognised Shift of Risk
There has been an almost complete shift of risk onto the general public and away from employers. This is very challenging, yet so poorly understood. In order to cope with these risks, it is necessary to recognize and understand them fully. Once you appreciate and understand the risks you face, you are then able to find ways to mitigate them. Everyone who owns or lives in a house knows that they face the risk of burglary, fire or flood. However, not everyone who is saving for their retirement is aware of the risks of poor equity market or investment returns, high charges and expensive annuitisation. Private pension income becomes increasingly important to avoid poverty in later life as Government and employers pull out of providing a social welfare underpin.
The old assumption that stock markets could always be relied on to deliver long term strong returns has left many people facing an impoverished old age. If you are unable to afford to lose much of your pension savings when markets experience sharp falls, you can now consider protection against this eventuality. You may be able to help mitigate losses, but still leave some potential for investment growth and better than just relying on low-yielding bonds. It’s up to you to decide, but you will at least want to make sure you know what your options are before its too late.
Even Pensions are globalised now. There are numerous factors to consider which realistically only an independent professional can guide you fully. Huge regulatory changes are afoot in financial services so if you get a globally competent adviser who is UK authorised and regulated – keep him or her. What is clear is that the tax burden on society leaves little for future ‘state pension benefits’. For the foreseeable future responsibility for our own financial affairs and financial security is essential if we are not to be subject to political maneuvering and possible poverty in the golden years.
To find out more contact Gerard Associates Ltd. Global Wealth Managers and Independent Financial Advisers.
Take control of your pension fund.