If you’re one of the 85% of private-sector workers who pensions specialist Dr Ros Altman reckons are in ‘defined contribution’ or ‘money purchase’ pension plans, your prospects for a comfy retirement aren’t looking too good right now. Not only are financial markets taking their toll on pension pots, but the size of income your fund will buy is falling too. “Annuity rates have halved since the early 1990s as interest rates have fallen and we all continue to live longer,” says Patrick Collinson in The Guardian.
A 60-year-old male retiring now can expect to receive a maximum, inflation-adjusted income of £3,968 a year (from Canada Life) in exchange for a lump sum of £100,000, according to Annuity-bureau.co.uk. For a female retiree, that drops to £3,721 (from L&G), largely because women outlive men – on average by around five years. As Collinson says, the sums are “paltry”. And it could get worse as annuity rates tend to track gilt yields. These may well keep falling as investors pile into government-backed debt as they fret over deflation and the security of other assets.
So, how can anyone close to retirement maximise their pension? The obvious answer is “don’t buy an annuity”, but sadly you have no choice. Pension rules require that a minimum of 75% of your retirement fund is used to buy one with no more than 25% taken as a lump sum. So what else can you do?
First, shop around – don’t just take the annuity offered by your savings provider. Using The Annuity Bureau (0845-602 6263), for example, to find the best deal “could add up to 10% to your retirement income”. Also think about whether you can afford to defer your retirement. A money-purchase lump sum can be exchanged for an annuity between the ages of 50 and 75. Based on current rates, the annual income you could receive from £100,000 as a male retiree jumps by around 20% if you retire at 65 rather than 60.
If you’ve a while left before retirement, another way to boost your pension fund is through ‘salary sacrifice’ while you’re still working. In short, you agree to take a lower salary from your employer, saving them employer’s national insurance (NI) contributions, in return for a bigger contribution to your pension. Some employers will agree to add the NI saved to their pension contribution. Combine that with the income-tax relief available on contributions (at up to 40% for a higher-rate taxpayer) and the boost to your pension could be considerable. Finally, there’s the problem of falling equity markets. Tumbling stocks are fine if you have decades before you retire, but not good if you’re only a few years away. Recent falls have knocked around 24% off the typical fund, says The Daily Telegraph’s John Greenwood. A popular solution is the ‘lifestyle’ pension plan (see below) – but it’s not for everyone.
Minimise losses from falling markets with a ‘lifestyle’ pension fund
For anyone about to retire, the recent falls in equity markets are potentially disastrous. Barring a miraculous rally, many retirees will be cashing in a much smaller pension pot than they hoped. But with a bit of planning, there is a way to reduce the damage – through a ‘lifestyle’ fund. These are designed automatically to reduce the amount of your capital invested in risky assets such as equities, by gradually moving into less volatile alternatives such as corporate bonds and gilts over the five to ten years before you retire. The idea is that should equity markets then “fall off a cliff” just before your retirement date, you are less exposed to the drop. Such funds are common – most pension providers offer them – and some, such as Standard Life, will let you switch an existing fund over for free. So are they a no-brainer?
Definitely not, says the FT’s Alice Ross. You must look at your circumstances carefully. For example, anyone already in such a fund who is considering deferring retirement to increase their pension pot should watch out. If at a time when equities are falling your lifestyle fund automatically moves your capital, in line with your original retirement date, then you are effectively “crystallising any losses”. Your capital will then be left sitting in relatively poorly performing assets. Should stocks then recover between your original and revised retirement dates, you’ll miss out on any gains.
These funds may also not suit anyone with a fairly small pension pot, since any plan that automatically reduces investment risk will also shrink returns. Bonds and cash rarely outperform equities other than over very short periods, and any cash invested in them will never build up to anything other than a modest pension. So if you’re starting your pension contributions late, or your existing pension is tiny, the bottom line is you’ll need to take some investment risk to generate a decent lump sum on retirement.