Most people approaching retirement choose between two solutions which are in many ways polar opposites, a lifetime annuity or flexi-access drawdown. While both play a key role in retirement planning, the idea of a single product for life is increasingly irrelevant.
Given that income needs are likely to change during retirement, retirement plans should be frequently reviewed and all assets should be considered in meeting your clients’ objectives.
Below we explore the multitude of solutions that are available and how they can be layered together for a better blend of security, flexibility and control.
Final salary pensions provide a guaranteed income for life, usually increasing each year to offset inflation. They can offer valuable peace of mind. In the ‘swinging sixties’ they helped to make retirement a relatively simple process. Generally, men retired at 65 and women at 60 and around twelve million people benefited from a final salary pension. Combined with the state pension, this provided an adequate income for most people.
Financial planning often consisted of answering one simple question - should I commute part of my pension for a tax-free lump sum? Fewer people have final salary benefits today and even fewer will in the future. In fact, there isn’t a single FTSE100 company providing a guaranteed pension based on final salary that remains open to new entrants1.
Many people retiring now will have a mix of final salary benefits and money purchase benefits. Clients that are planning to retire early may find that their expected income from a defined benefit scheme is reduced significantly. Fortunately, there are ways to accommodate early retirement without taking benefits from a defined benefit arrangement.
- Tax-free cash could be used to invest in tax efficient products or to repay debt.
- Tax-free cash could also be used to provide a rainy day fund for unexpected expenditure.
- The income from defined benefit schemes is guaranteed, so it's useful to offset against essential expenditure.
The combination of a longer retirement, coupled with the demise of final salary schemes, is creating a precarious environment for some of today's retirees. It's creating a greater need and opportunity for financial advisers to help clients skilfully navigate this complex environment and to help them achieve a comfortable retirement.
Defined benefits can be layered with other assets to build robust and flexible retirement plans for a better blend of security, flexibility and control.
1The future of defined benefit pension provision, KPMG, June 2015
Since pension freedoms, the number of people accessing their pension pot using flexi-access drawdown has increased.
In 2018/19 75% of pots over £100,000 that were accessed went into drawdown1.
Given that income needs are likely to change during retirement and there is no single pattern of expenditure, it's not surprising that drawdown is proving so popular because it provides flexibility.
Clients can take whatever they want, whenever they want, so long as they have enough money. They can keep their money invested in assets and any balance on death can be passed on to dependents.
While drawdown addresses many of the challenges clients face during retirement, it may also expose clients to some risks. These include:
- Longevity risk - Drawdown clients face the possibility of outliving their savings if they live too long.
- Withdrawal risk - Taking too much income too soon can exhaust a drawdown fund prematurely.
- Investment risk - A poor sequence of returns can have a devastating impact on a drawdown fund.
By layering drawdown with other solutions, your client can be provided with the flexibility they are looking for, as well as having security and peace of mind. There are various other assets and solutions that can provide your clients with an income during retirement and deserve consideration including, fixed term annuities, equity in the home, savings and investments, to name just a few.
Who might benefit from drawdown?
Drawdown may help:
- People who have a sizeable fund and can manage market volatility.
- Those who have significant DB benefits and/or other assets.
- Clients who actively enjoy managing their money in retirement.
- Younger people who are keen to access tax-free cash, but not ready to take an income.
- Anyone who values the flexibility to vary income and make ad hoc withdrawals.
- Those who want to maximize the amount of money they can pass on after their death.
Today we have a situation where most people approaching retirement choose between two solutions which in many ways are polar opposites, a lifetime annuity or flexi-access drawdown.
Undoubtedly, there are benefits and risks to both drawdown and annuities. With drawdown investment markets could be poor, the client may end up taking an unsustainable amount of income, they might outlive their funds, they could get caught out by sequencing of returns risks.
Annuities on the other hand are a lifetime decision, the income is fixed and there is no opportunity to take adhoc amounts. Your client could also get a better rate as they get older and their health deteriorates as it opens up enhanced annuity options. However, annuities can act as a foil to drawdown and vice versa. They’re a powerful counterpoint.
Given that income needs are likely to change during retirement, retirement plans should be frequently reviewed and all assets should be considered in meeting clients’ objectives.
1Retirement income market data 2018/19, FCA
Equity in the home
The increase in life expectancy and the demise of generous final salary schemes means that many people will need to leverage all of their non-pension assets, including the equity in their home. Many of your clients approaching and in retirement may potentially have more wealth in their home than in their pension pots as Britain’s over-55s hold around £1 trillion in housing wealth.
Whether to help generate an income, maximise tax efficiencies or for legacy planning, equity in the home can be used in a variety of different ways as part of a holistic retirement plan.
We've given a short overview of some of the options:
- Downsizing - At the point of retirement or at a later date, it can make sense to downsize. The house may be too big after the children have left home and the upkeep of the home could become challenging. The money freed up from downsizing could be used to help fund retirement, support family or pay off a mortgage. However, the cost of moving also needs to be taken into account, stamp duty, solicitors and estate agent fees alone can see costs run into thousands of pounds which can significantly reduce the proceeds made from downsizing.
- Equity release - It’s sometimes suggested that retirees occupying larger homes should free up this housing stock for families. Yet 49% of those wanting to downsize found a lack of suitable properties available. Inflated prices, high moving costs and a lack of availability are proving problematic for potential downsizers. Many people are reluctant to sell the family home. They value their neighbours and the local community they’ve lived in for many years and don’t always wish to move. These are just some of the reasons which can make equity release an attractive alternative. Any equity released is tax-free and it could be used to provide an income for your client. It could also be used to make a potentially exempt transfer which under current legislation is free of Inheritance Tax if the donor survives for seven years after making the gift.
- Residence nil rate band - From April 2020, up to £500,000 or £1m for a married couple, can be passed to a direct descendent on estates worth under £2m using the nil rate band and the new residence nil rate band. It could make sense to ring fence the amount that is free of Inheritance Tax.
- Rent a Room scheme - It may also be worth mentioning the government’s Rent a Room scheme. This isn’t about leveraging the equity in the home, but renting a furnished room in the client’s main residence has a potential tax benefit. Under the scheme, someone renting a room can generate a tax-free income of up to £7,500 per year.
Some of your clients' approaching retirement may be considering using the equity in their home to free up cash, maximise tax efficiencies or for legacy planning. Whatever your client’s overall retirement goals, property can play a key part in a layered approach to retirement planning where all your clients assets are used to produce the best possible outcomes.
Fixed term annuities
The changing nature of retirement means that flexible, tailored retirement plans that are reviewed frequently are essential to ensuring good client outcomes. Fixed term annuities can provide a regular, guaranteed income and can be used to cover your clients’ essential spending for a fixed period, to bridge an income gap or to allow clients to keep their future options open.
With a fixed term annuity, an income can be paid for a fixed term between 3 - 40 years and a maturity value can be paid at the end of the term. Your client then has the flexibility to decide to buy a lifetime annuity, invest in the markets via flexi access drawdown or take the payment as cash. Alternatively, it may make sense to choose another fixed term annuity.
Fixed term annuities offer security, but with a degree of control. Some products also include the option to take an ad hoc lump sum from the maturity value at any time. There are also plans which do not offer a maturity value at all.
Who might benefit?
A fixed term annuity could help you support your clients through a number of different stages in their personal retirement journey:
- Retiring early before any DB benefits start.
- Anyone looking to only take tax-free cash and leave their funds in a safe environment.
- Deciding to defer the state pension.
- Consolidating investment gains and parking funds temporarily.
- Those anticipating a change in circumstance before they commit to a lifetime annuity.
- Clients looking to take their entire fund as cash, but wanting to minimise the tax they pay.
A guaranteed income with flexibility could provide your client with the peace of mind and security they are looking for. Fixed term annuities can be layered with other assets to build robust and flexible retirement plans for a better blend of security, flexibility and control.
The risks should also be considered
When choosing a fixed term annuity your client should consider:
- The plans don't pay income for life.
- If your client uses the maturity value to provide them with further income, the value may not be enough to provide the same level of income they were receiving during the plan term.
Before pension freedoms, if someone was lucky enough to have a choice, then the choice was largely binary, Annuity or drawdown.
Now we have many more options; fixed term annuities, lifetime annuities, drawdown, taking the fund as cash and uncrystallised funds pension lump sum. But as you’re well aware, it’s not simply a matter of choosing between a longer list.
Using certain solutions in combination can provide better outcomes. For example, there are a number studies providing empirical evidence that combining an annuity with drawdown can often produce better outcomes1.
It’s probably fair to say that in the recent past lifetime annuities have been deemed to have ‘gone out of fashion’, but annuities still have an important place in modern day retirement planning:
- A guaranteed income. Many people want to focus on enjoying their retirement, rather than worrying about their investments. Recent research found that there is a correlation between health and wellbeing, and the retirement income choices people make2.
- Life expectancy has continued to rise alongside medical advances and improvements to the standard of living. Due to the number of contributory factors, it's almost impossible to accurately predict how long a client will live for and you'll need to make your best estimate using the information available. Using a lifetime annuity as a way to underpin your clients’ essential retirement living costs is one of the only ways to truly mitigate the risk of a client outliving their income.
- It could provide your client with a higher income than you might expect.
- Your client may benefit from an enhanced rate, if they have certain health or lifestyle conditions, such as smoking or being overweight.
- It could be used to meet your clients’ legacy objectives. Annuities can now provide much more flexibility on death. Guaranteed periods up to 30 years are offered on lifetime annuities. Value protection and beneficiaries’ pensions can also now be paid to any beneficiary.
Who might benefit from a lifetime annuity?
- A lifetime annuity can underpin your client's essential retirement spend giving them security and peace of mind. It could also provide flexibility to take more risk with other assets in their portfolio because they have a guaranteed income for life.
- Clients that are in the later years of their retirement. At older ages the income from an annuity is very difficult to match using drawdown.
- Clients with medical or lifetime conditions. This is particularly relevant where there is an expectation of a shorter life expectancy, but the prognosis is unpredictable.
A guaranteed income for life could provide your client with some peace of mind and security they're looking for. Lifetime annuities can be layered with other assets to build robust and flexible retirement plans for a better blend of security, flexibility and control.
Buying a lifetime annuity is a once and for all decision. Once their annuity is in payment your client can't change any of their payment options, even if their circumstances change.
1Are annuities missing asset class for sustainable drawdown? Money Marketing
2The Retirement Income Riddle, Demos
Savings and investments
As you’ll know, retirement planning goes beyond looking at a client’s pensions.
Below we've summarise some of the savings and investment options that could be used to supplement pension savings from non-pension assets in a way that is largely tax-free. While tax may not be the only objective clients have, paying less tax is probably a desirable outcome.
Here are some tax efficient savings and investment products that could be considered:
- Personal Savings Allowance - Basic rate taxpayers can earn up to £1,000 interest a year without having to pay tax on savings accounts. Higher-rate taxpayers can earn up to £500 interest. The interest free allowance does not apply to people paying the additional rate of income tax.
- Premium Bonds - From £25 to £50,000 can be invested in premium bonds and any winnings are tax-free. Premium Bonds are popular though the chances of winning are 24,500 to 1 for each £1 bond number.
- ISAs - There is no additional income tax or capital gains tax payable from an ISA, so income can be taken tax-free (though there is a 10% tax credit on any dividend income).
- Investment bonds - Up to 5% per annum can be taken free of any personal income tax if someone is a basic rate tax payer, assuming the withdrawal doesn't take them into a higher rate band. There is no income tax payable for higher rate taxpayers immediately, but there may be liability for income tax after 20 years.
- Unit trusts, investment trusts and OEICs - Dividends payable from funds invested in shares are only taxable once these exceed the dividend allowance of £2,000. There is also the capital gains allowance of £12,000 (2019/20). In this way, these investments can be used to provide a tax-efficient income in retirement.
Other objectives may drive the choice of solutions selected to provide retirement income. For example, if leaving a legacy is an objective, ISAs can be passed on death free of IHT to a spouse or civil partner. If long-term care costs are a concern, investment bonds are disregarded in any financial assessment for care funding, although if the bond is bought with this in mind the client could fall foul of the deprivation of assets rules.
When you’re reviewing your clients’ non-pension assets alongside their pension assets, it can provide an opportunity to truly layer a range of solutions together to build more robust and flexible retirement plans that help your clients achieve their retirement objectives.
The State Pension is the main source of retirement income for many retirees. However, many people don't really understand the State Pension and how it will work for them, particularly following changes from previous reforms.
Below we've summarised the key information to support your client conversations
The full State Pension scheme now pays a flat rate amount of £168.60 per week and the amount your client will receive is based on their National Insurance (NI) record. Although the State Pension can provide a reliable and stable income, it may be necessary to consider other assets to meet your client’s retirement objectives.
Below we've summarised the key information to support your client conversations.
There are a number of key considerations to be aware of:
- The maximum payable to anyone with a NI contribution record of 35 years is £168.60.
- Someone who would have received a higher pension under the previous system will retain this right.
- The government will increase the amount payable by 1% for every 9 weeks’ payment is deferred.
- The State Pension will increase each year by whichever is highest - earnings, prices or 2.5%.
- The qualifying age for the State Pension is increasing to 66 by October 2020.
- There are further plans to increase the State Pension Age from 66 to 67 between 2026 and 2028.
Benefits for your client:
- The State Pension is a guaranteed lifetime income so it's useful to offset against essential expenditure.
- If deferred, the amount payable increases by just under 5.8% each year so this could be worth considering.
People are retiring gradually, perhaps working part time or in a less well paid, but more personally rewarding role. Alternatively, they may retire early before their defined benefits or the State Pension become payable. In these circumstances, they may need a temporary income or something that will bridge the income gap.
People who're naturally risk averse or reluctant to take risks with their funds close to retirement, may prefer the guarantee of a regular income and a guaranteed maturity value. Fixed term annuity products can be invaluable in the right circumstances, but they're a temporary solution, so another solution or combination of solutions is required at the end of the term.
In some cases, the State Pension in isolation may not provide enough income to meet your client’s retirement objectives. Whether it is claimed at outset or deferred, the State Pension can be layered to help build robust and flexible retirement plans.
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Retirement has changed. Find out what this means for retirement planning and how a multitude of solutions can be layered together to help achieve your clients’ objectives.
Find out why a layered approach to retirement planning could benefit you and your clients.