How to make the best of a bad deal if your pension pot has been badly hit

Published on Friday 9 January 2009 18:20

IF YOU have a defined contribution pension you may be awaiting your forthcoming annual statement with a degree of trepidation. Some will have fared better than others, but for most the statements will make grim reading.

The events of 2008 have sorely tested the principles of Modern Portfolio Theory, with even cash seeming very risky at times. The theory, proposed by H Markowitz et al, describes how returns should be optimised and volatility minimised by diversification across a range of uncorrelated assets (cash, property, shares and bonds).

A look at the average 12-month performance of the most popular collective pension fund sectors says it all. UK All Companies funds were down over 30 per cent, while Balanced Managed, Global Equity and property funds all lost around 20 per cent or more, according to Financial Express. Only Global Fixed Interest funds produced positive returns, with 22.19 per cent, and that was entirely down to the sliding value of sterling against other currencies, especially the US$ and the euro.

For those whose retirements are still some way off, there is perhaps less concern as, given time, asset values will recover. But what about those who are near retirement and have seen the value of their pension pots fall by 20 per cent or more?

Firstly, the events of 2008 should serve as a salutary lesson. Investments (including pensions) should always be "de-risked" as the time when they will need to be called upon approaches. Assets should be switched into cash or near-cash investments in tranches, commencing around five years out from retirement.

Such wisdom coming after the fact will provide no comfort to those who did not take such measures and are now on the brink of retirement. So what can or should you do if you are among the many thousands of individuals who expected to retire this year using benefits from DC pensions?

The first option is to work on and revisit your investments to position them for a recovery to their mid-2007 levels sometime in late 2010 or early 2011. This is a depressing prospect, so what are the alternatives if one wishes to stop working in 2009?

Assuming you have insufficient capital or other sources of household income to enable you to defer taking any benefits from your DC pension pot, the key may well lie in the ability of pensions to give up 25 per cent of their value in the form of tax-free cash (known as a Pension Commencement Lump Sum, or PCLS). It is possible to take all or part of this benefit and to defer drawing income or annuitising the remainder of the fund.

This concept is perhaps best demonstrated using an example. A 60-year-old male with a 100,000 pension pot would be entitled to a PCLS of up to 25,000. The balance of 75,000 could buy a net annuity income (assuming liability to basic rate tax) of up to around 350 a month. Instead of buying an annuity, the whole fund is placed into an Unsecured Pension (USP) arrangement and the tax-free cash is drip-fed at a rate of 350 a month. Even assuming no investment growth, the PCLS could provide income at this level for almost six years, allowing the pension funds to remain invested and to, hopefully, increase in value over this period.

Availing one's pension pot to this kind of flexibility will usually involve transferring the funds to an appropriate alternative arrangement and this will necessarily also involve some cost. Advice should be sought from an appropriately qualified and experienced financial planner, preferably one who will agree a fee. The fee can generally be met by way of a deduction from your pension fund – and remember, everything is negotiable.

&#149 Paul Lothian is a director of Verus Chartered Financial Planners in Dundee.