Gareth Shaw: Follow the yellow brick road to pension freedom

The start of the Wizard of Oz sees Dorothy living a mundane existence, shackled to her sepia-bathed Kansas farm with her fusty aunt and uncle and bemoaning the lack of adventure in her life. It's only when a tornado strikes that Dorothy and her loyal sidekick, Toto, are thrust into glorious technicolour and given the freedom to roam in a new land, with all the thrills and spills that come with that liberation.

Now that there is no necessity to buy an annuity on retiral is a bit like moving to The Wonderful World of Oz from a very dull Kansas, opening up the realm of income drawdown and freedom to choose what to do with your pension pot.

I like to think that Britain’s retirees have been taken down a similar yellow-brick road recently. In the sad, monochrome years prior to 2015, most people were stuck in Kansas when faced with the decision of how to generate an income in retirement – forced to buy an annuity, which provided a valuable guaranteed income for life, but had become tired, inflexible and increasingly poor value for money.

Then former chancellor George Osborne – the pensions equivalent of Professor Marvel – created a hurricane for retirees by removing the obligation to buy an annuity at retirement. People were free, from age 55 onwards, to take as much out of their pension as they wanted – whenever they liked. In doing so, he opened up the kaleidoscopic world of income drawdown – to the 100,000-strong crowd retiring every year. An option that not only keeps your pension savings invested in the stock market, but also allows you to access your money as often and at the level you want.

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Since the pension freedoms, as they’re now known, were introduced two years ago, income drawdown has stopped being the preserve of the wealthy and is fast becoming the mainstream option for people wanting to generate an income from their pension savings. Figures published last week by the pensions watchdog, the Financial Conduct Authority, confirms this trend. 30 per cent of the half a million people who’ve accessed their pension for the first time in the past year, did so using income drawdown – double the number of people that bought an annuity.

With income drawdown becoming the new norm and more people maintaining their exposure to stock market risk throughout retirement, the stakes couldn’t be higher. You are investing to provide an income throughout your retirement, however long it lasts. It’s vital, therefore, that you have an investment strategy that’s built to help you generate regular income and, most importantly, ensure your funds aren’t exhausted too 

So, what are your options?

Well, there are principally two strategies for you to consider. However, much of your choice will come down to your attitude to risk and comfort with the potential for the value of your pension pot to fall, other sources of income you might have and your long-term ​plans. Part of the apathy towards annuities was that, if you died before you’d been paid back what you put in, none of the ​remaining funds could be passed on to your loved ones. Income drawdown allows you to leave some, or all, of your pension fund behind to your family (after the taxman takes his bite). So, if that’s important to you, it will influence how you invest.

One approach is to take a ‘natural income’ from your investments. This involves buying assets that generate an income, such as shares (which pay dividends) and corporate bonds (which pay interest). In theory, this approach means you can ​receive an income from your portfolio, leaving your capital invested in the hope it maintains its value or grows over time. Another option would be to choose funds that aim to generate a regular income – such as equity income funds – as well as preserving your capital.

Of course, this means your income would be limited to the amount paid ​out ​by the investments you make. It would typically be possible to generate around 3 or 4 per cent in this way from a combination of dividend paying shares and lower risk corporate bonds. If you want more income but want to keep as much of your original pension fund as possible (say, to pass it on after you die), you’ll need to go up a notch on the risk scale, considering smaller, more risky companies that potentially pay higher dividends, or lower quality bonds that pay higher interest. And with that, comes additional risk of losses.

The other common option is called ‘selling down’. If you need much more income than is produced naturally by your portfolio and you’re comfortable reducing the value of your pension, this option involves selling your portfolio gradually over time. With this strategy, you’ll be looking for ‘growth’ investments – perhaps shares that have the potential to increase in price – to replace some of the capital you’re withdrawing to ensure that you don’t exhaust your fund too soon. And of course, the amount of risk you take is important as going for ultra-high growth investment exposes you to a greater potential for loss. That, combined with regular large withdrawals, can seriously harm the longevity of your fund if not managed carefully.

These investment strategies may not seem alien to seasoned investors. But the thousands of new retirees looking at income drawdown as their primary option need to act wisely to make sure their pension delivers the income they need and is built to last for 30 years or more. Using a drawdown plan for retirement will mean swapping your work boots for a pair of ruby slippers, and you definitely won’t be in Kansas anymore.

Gareth Shaw is head of Which? Money Online