The new pension changes are here and I am really quite concerned. In the wrong hands the new pension freedoms could be and probably will be a big danger to people’s financial health. Quite literally some people could be left without any money, if they withdraw or spend too much from their pension fund when they retire. That is a scary but very real prospect for many people.
The new rules have promised the option of exit to anyone who has already bought an annuity, but I still think that many people will still be reluctant to buy one. Here’s the problem. No one yet knows who will buy back your annuity or even what price you would get for it. And if you are now in poor health why would anyone want to buy your annuity off you? If you were to die suddenly, the income from the annuity would cease immediately.
So the reality is that the changes that came in on 6th April are unlikely to change many people’s views on annuities and will still probably be attracted to Drawdown.
So how does Drawdown work?
Firstly, you have to keep your pension invested, and you draw income from it, as and when you need it. Sounds simple and probably makes a lot of sense to a lot of people.
But here’s the problem if you decide on this option. You have to try and answer these 2 questions.
First, how long do I think I will live?
And secondly, how much income can I afford to take from my pension?
If you get either of these substantially wrong, and you could easily run out of money before you die. That’s a pretty frightening prospect.
To answer to the first question, there is plenty of data to give you some guidance. Statistically speaking a man living in the UK will live to his mid 80’s and a woman somewhere close to 90. But what happens if you don’t live to a statistical age and live beyond normal life expectancy?
So what about the second issue? How much do I decide to spend of my pension fund each year?
How much do I withdraw?
It’s simple maths, that if you spend more than you earn sooner or later you will run out of money. Now if you knew how long you needed income to be paid for, it would be quite simple to work out more or less what you could spend. But that is the problem; we don’t know how long we need the income to last for. For example, if we withdraw an income of say 6% a year and the pension grows by 4% a year, we know that eventually we will go bust.
What investment returns will get?
The problem though is likely to be compounded even further by disorderly investment returns. Many people have not thought about this yet, but here is the issue. When you are growing your pension pot, the fact that in some years, the investment returns are good and some years are bad, is actually to your advantage. You buy more units in your pension in the years where the investment has not performed well and so long as the end value is higher, the ups and downs have actually helped you.
However, when you start to spend your pension fund money, the ups and downs in the stock market can have a very serious affect on your financial health. You see in the years that the pension fund performs poorly; more units need to be sold to give you the same level of income. That can have a serious affect on your pension fund; i.e. it call fall in value dramatically and quickly.
Ok, so what income should I take?
The general consensus is that income of 4% a year is regarded as sustainable. What that means is, is that if you take 4% income a year, it’s reasonable to expect currently that an investment return of 4% could also be achieved. If the growth is higher, even better.
But even a 4% income withdrawal could prove to be too high, especially if investment returns are lower than expected.
So what is the alternative? You could consider taking only the natural yield from investments.
In other words, instead of taking a percentage of your investment you withdraw only the annual dividend pay-outs in the case of shares, or the coupons in the case of bonds, leaving the capital untouched. With careful investing, current natural yields should allow an income of 3% or 3.5%.
So what’s the answer?
Drawdown in itself is not a bad thing, but you need to understand what the risks are and be as sure as you can be that you are not going to run out of money. In my opinion it would be prudent to have a level of guaranteed income that will at least cover your essential outgoings. This could be State Pension, Annuity income or a scheme pension from a Defined Benefit scheme. Knowing that your bills are covered will certainly help you sleep at night.
On the other end of the spectrum of course, you may not spend enough of your pension fund and at the end of your life you have been too cautious and have a substantial pension pot that has not been spent. Your children may of course thank you for that.
Planning your retirement can be a serious challenge for all of us and getting this part of planning your money could and most likely will affect you for the rest of your life.
If you are at all concerned about how to start taking your pension income, give me call today to arrange a discovery meeting, to see how we can help you.
Always consult a qualified financial adviser before making any tax or investment decisions. The above article is only for guidance and should not be taken as advice. If you would like to talk to me about getting your future investments on track please contact me.
Contact Martin Dodd on 01902 742221 or email him at [email protected] if you would like talk about money issues.
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