Pension
Income
Investor

Step 5: The end game – how to maintain your income in the later years

In Step 4 we covered how to maximise retirement income from a fixed pot of money by augmenting the natural income with withdrawals from capital. This step deals with the problems that arise 20 or more years into retirement, where you are not likely to want uncertainty around your income and remaining capital.

The need to buy an annuity later in life

As you take an income, you can expect the amount of money left in your pension pot to decline each year. This makes sense, because as you get older the total amount of capital needed for your remaining lifespan is less. Remember though that our inheritance portfolio is designed not to decline in value each year, because just the natural income is taken from it, leaving the capital untouched and able to grow. If you intend to invest in this portfolio, you need not read this chapter.

If you knew exactly how long you would live, the method of gradually depleting your capital would work perfectly right to the end. Unfortunately, longevity is unknown, so the method breaks down as we age – living even one year longer than expected would mean a year with no income from your once-large pension pot.

And, once you have started on the path of gradually spending your capital, you cannot revert to limiting withdrawals to the natural yield without seeing your income fall significantly. Taking a 4% income from a reduced pot of £400,000, for example, is not the same as taking a 4% income from a pot that began at £500,000!

The solution? We come back to the annuity.

We have always believed that annuities did not become completely redundant as a result of the collapse in the rates they pay and the new pension freedoms introduced in 2015. What is clear is that annuities ceased to be a viable way for most people to transform a lifetime of savings into an income for life at the point of retirement at 65.

But annuity rates improve as you age, as the following shows.

Age        Starting income on £100,000 annuity
65          £2,780
70          £3,225
75          £4,179
78          £4,795
80          £5,320
82          £5,880
85          £7,000
87          £7,975
90          £9,750

Notes: Annuity income guaranteed to rise by 3% per year. Your spouse will get 50% of the income if you die first. Source: Legal & General

This means that, by your late 70s or early 80s, you should be able to get an annuity that replaces the target income from the portfolio, adjusted for inflation – provided that your pot has not been depleted excessively. The 1% annual limit on capital withdrawals introduced in Step 4 was designed with this aim in mind, with a margin of safety added.

If your pot simply maintains its value – which means that its value grows by 1% a year, cancelling out the asset sales (and it’s not unreasonable, based on historic trends, to expect much better growth than that) – then at age 80, say, you will be able to lock into a guaranteed income for life that is better than you would have received had you bought an annuity at the point of retirement.

Those who have the compromise portfolio and intend to leave a legacy will use only part of their pot to buy an annuity, spending enough on it to produce their target income. There will, if all has gone to plan, be enough left over after the annuity purchase to leave something to your heirs. This money can remain invested as before or, if you wish, it can be switched to the inheritance portfolio.

There is another benefit from buying an annuity at some stage: it avoids the danger of ‘over-saving’, by which we mean the failure to spend all of your retirement pot on its intended purpose of providing a comfortable life in retirement.

This could easily be a danger if your investments perform well, but where you are understandably cautious about increasing your pension withdrawals halfway through your retirement for fear of going too far in the other direction. Buying an annuity cuts through all these conflicting considerations and simply uses all of your remaining capital (or the proportion of it that you choose to allocate to the purpose) to provide an income for the rest of your life.

Finally, getting your income from an annuity involves no effort or maintenance, so it is ideal for the later stages of retirement, when you may not have the energy, health or inclination to monitor a portfolio of investments.

If you are worried about how your spouse or partner might manage dealing with finances after your death, an annuity again provides a solution in that it would require no management on his or her part (as long as you buy the type of annuity that pays an income to a surviving spouse; the technical name for this type is ‘joint-life’).

A price for security: ‘I spent £80,000 on an annuity to pay my service charges and electricity bills’

One man, aged 76, with a wife of similar age, describes how he manages their joint savings and investments to provide an income.

He found their investment income adequate but somewhat variable. To reduce risk and make the general management of household bills easier, he spent £80,000 to buy an annuity that would pay out for the duration of both his own and his wife’s lives. The payouts would rise at 3% per year, which is more than the Bank of England’s target rate of inflation of 2%.

He said: “We live in a small flat where we do not have a mortgage but where the service charges are about £2,000 per year. We have no gas and our electricity bills are around £900 a year. The annuity means these things are fully covered and I have the security of knowing they will be covered for my wife when I die.”

At the time of writing, if you spent £80,000 on an annuity attached to the lives of a couple each aged 76, and rising at 3% per year, your payouts would start at £3,025 per year. That may not seem much – but there’s a price for security, and this man was clearly happy to pay it.

‘People are taking lump sums well before retirement and buying annuities well after it’

By Richard Parkin, former head of pensions policy at Fidelity International, the investment firm, and a leading expert on pensions

Annuities are still being bought, but in far smaller numbers and with much bigger pension pots. The average value of annuities purchased from company pension schemes has jumped from around £20,000 to around £50,000 since the pension freedoms were introduced.

It’s interesting to note that annuities are generally bought by those who are at or even beyond their stated retirement age, whereas much of the other activity is happening a long time before retirement. Of those accessing their pension savings, nearly half had five years or more to go to their retirement date.

There’s also another, less often mentioned change to the rules that came with the new freedoms, which was the taxation of pension savings when someone died. Now, pension pots left behind are almost invariably free of inheritance tax and may be free of tax altogether.
This is leading people with other assets to use those first, so reducing the size of their estate.

In general, I expect people to start taking lump sums from their pensions in the run-up to retirement. They may continue to do this through retirement, perhaps to top up earned income or bridge the gap between retirement and when other pensions are paid. Finally, they may come back to annuities in later life if they need the income – but where they don’t the pension pot will be passed on to the next generation.

But this all works because many of those accessing their pensions now have plenty of guaranteed income from final salary pension plans. Future retirees won’t be so lucky.

‘People will start buying annuities again’

By Tom McPhail, head of retirement policy for Hargreaves Lansdown, leading pensions analyst and contributor to the development of government policy on pensions

Pension freedoms have proved immensely popular and since they came into effect sales of annuities have dropped. This is not the same, though, as assuming that annuities don’t have an essential role to play. Far from it: not only has annuity demand now stabilised, but I also
expect it to increase again in the future.

Annuities perform a couple of essential jobs that very few other sources of income can deliver.
They provide a risk-free income, and they pay out for all of your life, however long that may be.
This means you don’t have to worry about the economy slowing down, the stock market falling, dividends being cut or any other investment risk factor: whatever happens, you’ll still get your income.

It also means you have insurance against living too long.

Most of us go into retirement not knowing how long we need to make our savings last. This means we risk either running down our savings too fast, or not living well enough in retirement and then dying with unused savings in the bank. It is almost impossible to get this right
on your own, but an annuity does exactly that for you automatically.

I would always recommend people to cover essential household expenditure needs with a secure income. For many this might be their state pension and perhaps some final salary income too. For anyone without enough guaranteed retirement income already, the logical choice is to use as much of their pension pot as necessary to buy that additional secure income through an annuity.

Once this secure income is in place, it becomes much easier and safer to keep the balance of your retirement savings invested for a mixture of growth and income, drawing variable income from the investments.