THE growing army of pensioners keeping their cash invested when they retire instead of buying an annuity are endangering their life savings if they fail to plan carefully, experts have warned.
The continuing plunge in the value of annuities – still used by the vast majority of people at retirement to convert their pension pot into a regular income – has driven a shift towards more risky alternatives.
The main one is drawdown, where you keep your pension invested and take an income directly from it, either indefinitely, or until you decide to buy an annuity.
The appeal is obvious, particularly in the current climate of diminished investment returns, economic uncertainty and declining annuity rates. Not only does staying invested give you a shot at boosting your pension pot, but it improves your chances of protecting your retirement cash from inflation while providing the flexibility lacking in annuities.
Yet it comes with significant risks. The potential for losses when staying invested means the guaranteed income supplied by annuities is more suitable for the vast majority of retirees. There’s also the danger of the pension well running dry before you die, which is one reason why advisers typically recommend that anyone with a pension fund of less than £100,000 sticks with annuities.
But the reality is that with annuity rates crashing to record lows – thanks partly to the effects of quantitative easing – more people are willing to take their chances.
So how do you work out whether you’re likely to get more from your pot if you go into drawdown? This involves working out the critical yield. That’s the investment growth rate needed from a drawdown fund to produce an income at least equal to that provided if an annuity had been bought instead.
It’s not as simple as it sounds, however. For example, you might want the same or more income than you’d get from an annuity but without eating into your capital. Unfortunately, that’s a case of wanting your cake and eating it, according to Carl Melvin, director of Affluent Financial Planning in Paisley.
“You should be made aware of the likelihood of capital depletion if maximum drawdown income is taken, especially within a low-risk fund. The reality is that fund depletion is a probable outcome from drawdown, rather than a remote possibility,” he said.
The critical yield – which takes charges into account – will help dictate the level of risk taken with investments. If it’s an ambitious growth target then the amount of risk taking required may be one with which the investor is uncomfortable. The key to making your money last and providing the income you need lies in how effectively your pension pot is invested.
If you’ve decided to go into drawdown, you’ll need – preferably with the help of a professional adviser – to work out an investment approach. This will be complicated for many people by the lifestyle strategy employed by their pension fund.
This is where the pension pot is moved into lower-risk assets as retirement approaches, with the equity element gradually reduced in favour of bonds and cash.
It makes sense on paper – despite concerns over falling gilt yields and warnings of a bond bubble – but it’s not ideal if you’re staying invested into retirement.
“A low-risk, high bond-content fund is not appropriate in the long-term for drawdown as it will not achieve the growth necessary to achieve the critical yield required,” said Melvin.
“So a frank discussion about risk and reward is essential to dispel the notion that you can have an income from drawdown equivalent to the annuity plus keep your capital value all within a low-risk fund.”
How you invest in drawdown also depends on your intentions. If you think you’ll buy an annuity further down the road, for instance, the investment strategy could be based on outperforming the low-risk assets that underpin annuities, said Richard Libberton, private wealth manager at Anderson Strathern Asset Management in Edinburgh.
“Generally, this would mean that a higher proportion of equities would be required in a drawdown pension,” he explained. “Investors will have to be comfortable with this approach, when traditionally they would be looking at lower risk strategies to protect their hard-earned savings.”
But if you don’t plan to buy an annuity at a later date, you could take a different approach.
One option is to earmark some of your pension pot for your regular income – perhaps keeping it in cash or fixed interest – and pile the rest into equities. “However, this may drag down the performance of the remainder of your pension portfolio,” said Libberton.
Another possible route, he added, is to invest largely in income producing assets such as high-yield equities, corporate bonds and property.
As Libberton points out, diversification is essential whichever way you choose to invest. If you’re thinking of drawdown you should take advice, given the decisions to make and the potential pitfalls.
“Drawing income from your pension clearly provides greater flexibility for your retirement income over purchasing an annuity,” said Libberton. “However, it is not for the faint-hearted and specialist pensions and investment advice should be sought before venturing down this path.”