How do you avoid running out of money when you retire? This is a question more and more investors need to ponder as our retirement options expand. In the past, most of us had to use our pension pots to buy an annuity (an income for life) from an insurer.
But in the last five years, annuity rates have plunged, and retirement income along with them. Many people are also reluctant to swap their pot for an annuity: if you die prematurely, your relatives won’t get a penny of it.
So it’s nice that we have other options these days. You can opt for income drawdown: you leave your pension invested, and take an income from it. And if you’ve saved using an individual savings account (Isa), rather than a pension, you can do what you like with it.
But there’s one big problem: how much money can you withdraw? Take too much from your pot each year and you might run out of money before you die. Take too little, and you risk limiting your lifestyle needlessly.
How to make your pension pot last
The correct drawdown rate depends on three critical factors, none of which you can know for sure:
• Your lifespan: how many years will you be drawing down this money for?
• Your investment returns: how much can you make on the money still invested?
• Your cost of living: this dictates how much your income must rise by each year to maintain your buying power.
Buying an annuity does away with the first issue – you get paid until you die, regardless of when that is. On the second issue, you’ll also know exactly what income you’ll get. As for the third, you can also get a cost of living allowance factored in when you buy an annuity.
It all comes at a price, but the benefit is that you get certainty. If you’d rather avoid an annuity, you must plan for each of these factors yourself. The government realises this, so it has set limits on income drawdown, to try to ensure pensioners don’t run out of money. If you have a secure income of £20,000 a year, you can take out as much as you like (‘flexible drawdown’). If you don’t, you are subject to a ‘capped drawdown’ rule.
The amount you can take is based on 15- year gilt yields and Government Actuary Department annuity tables. Just now the rate for a 65-year-old man is £58 per £1,000 invested. You can withdraw 120% of this rate, so someone with a £100,000 fund can take £6,960 of income in the first year. (These rules don’t apply to Isas, but these calculations will give you an idea of how long your Isa pot would last.)
How does ‘maxing-out’ your income drawdown work in practice? Not well. Assuming you don’t want to risk all your money in stocks, a well-diversified portfolio will conservatively give a 4.5% return after charges. If you withdraw 6.96% at the start of each year, your fund will gradually shrink, and your income drop each year. After 30 years you’ll be getting just £3,000 a year, and you won’t have much of a pot left.
Keeping up with inflation
This isn’t good. To maintain your living standards, you need a rising income each year. So you must drawdown less than your annual return. Assuming a 4.5% return each year, on a £100,000 pot, you could take out £4,000 in year one (4%), then grow your payout by 3% a year. At this rate, your money would last 30 years.
The trouble is, a bear market in the early years could destroy your plan. If your fund falls by 10% in each of the first three years, then a £100,000 starting fund would be worth just under £63,000 at the end of year three. Continue to take out a rising income, and you would run out of money after 18 years.
You could put all your money into something safer, such as index-linked gilts, and get a return of, say, 2.8% a year. But you will have to withdraw even less money. Take out just £3,000 in year one, and grow that by 3% a year, and you’d still run out of money after 32 years.
You might instead invest in dependable dividend-paying shares, such as those of utilities and telecoms companies. This might work well, and deliver a rising income over the long haul. But the companies have cut dividends in the past. And their share prices can also be volatile, so it’s a high-risk plan.
Remember the golden rule
In short, income drawdown remains a high-risk strategy, suited to people with very big pension pots and an alternative secure income. Given how hard it is to get a safe, rising income stream, the security offered by annuities – meagre as current rates may be – can compare quite favourably.
For example, a 65-year-old man with £100,000 can buy an annuity that grows by 3% a year, starting at £4,222, and he won’t have to worry about running out of money.
If you do opt for an annuity, just remember the golden rule: shop around. If you are ill, or a heavy smoker, see if you can get an ‘enhanced’ or ‘impaired’ annuity, which could add a great deal to your income. And if you’re married, don’t forget your partner – discuss your options, because if you die first, you don’t want to leave him or her in the lurch.
The digested read
• Income drawdown only makes sense for big portfolios.
• Get at least some of your income from annuities. Annuities are good at reducing risk.
• Withdraw less money each year than your portfolio’s expected return.
• Spread your investment risks across different assets.