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Recently, a new client came to me to seek investment advice. He told me that he had recently retired, had selected his income and needed help with how to invest his pension lump sum. He asked me if I could give him the best advice on how to manage his money more effectively. My answer reminded me of that joke again, where a man, when asked for directions to the station, replies, ‘Well, if I were you, I wouldn’t start from here.’ My reply to him was, ‘It is a shame that you didn’t come to me a few months ago before you made some of the biggest financial decisions of your life, because sadly you have already passed up some of the greatest opportunities’.
To be able to select the right options at retirement, you need to be able to organise your affairs correctly in the lead up to and at retirement. Forearmed is forewarned! I want to guide you through the tools you have available to use, so you too can get yourself organised before the event.
The Security Of An Annuity
When you get to retirement with a Personal Pension, your first choice is whether to take the tax-free cash or not. It used to be that in most cases this was a good idea; however, with the new flexibility people now have, the issue is less clear cut. The traditional choice, then, is to use the remaining 75% to purchase an annuity. You hand over all the rest of this money to a life company in exchange for a guaranteed fixed income for life. The income can remain level or they increase in line with inflation. An annuity can pay out a spouse’s income on death and can guarantee to pay out for a minimum number of years if you die early. Whichever options you select, if you live long into retirement, an annuity is a great investment. If you die early into retirement, the annuity company wins and you lose. Those who die early pay for those that live long.
Annuities are an insurance of a future income until you die. Annuities provide predictability, guarantees and security. For those who have only managed to save up the bare minimum they need to live, an annuity could be the best route, because they cannot afford to take any risks with this income. However, by opting for this route, they often accept a lower income for their lifetime. Annuity rates have been at an all-time low for the last four years, which translates into low incomes. Once you are locked into an annuity, you cannot then change to another provider if rates improve in the future.
‘Enhanced Annuities’ and ‘Impaired Life Annuities’ are also available on the market. All of your life you have wanted to answer ‘no’ to everything on a health questionnaire, but ironically in retirement you want to identify every ailment, doctors visit and accident you have had in order to get better annuity rates. The less healthy you are, the less time you are likely to live, thus the higher income they can afford to pay you. If you have had health issues, impaired life and enhanced annuities are certainly worth exploring; until you get a detailed quote that takes into account your health, you won’t know how much income you can generate from this route.
While annuities provide you with certainty, they also have problems. To begin, most people tend to opt for a level annuity rather than one that increases in line with inflation, because the income at the beginning of the latter is so much lower than that of the former. People tend to want to spend more in the earlier years, so they are often happy with this risk, but it is a risk with an unknown future: The higher inflation reaches, the poorer they get each year. This isn’t a very scientific way of overcoming this desire for higher income in the early years of retirement, but it is one that many people follow.
There is also the risk that your circumstances will change in the future after you have bought that annuity. You might pay for a spouse’s income to continue after your death, but you may then not have a spouse further down the line. You may start to generate another income of some sort and find that a fixed income just adds to your tax bill. You may need more income in one year than another, or need to create years where you have no income at all. Whilst a fixed income has its attractions, it also has its problems. The biggest problem with annuities though is that if you don’t get to use all of the money you have put into the annuity. Because you die sooner than expected, it is the annuity provider that benefits, not your loved ones.
In the Budget of 2014, George Osborne initially hinted at giving people more flexibility in what was later named ‘Pensions Freedom’. As already discussed, ‘Pension Freedom’, confirmed in the Budget of 2015, gave even more choice for investors at retirement. As a result of these announcements and consultations, the share price of some annuity providers fell by over 50%.
If annuities were good value for money, would this have been the case? I think not. Annuity providers have failed to innovate their products and have been supported by a legislative restriction. As soon as that restriction is lifted, they are exposed. They now either need to innovate quickly or face extinction. For some annuity providers, it is too late, but expect more innovative annuity solutions coming to the market post-2015, as these companies try to hang on to their market share.
Getting older might make you feel like you are slowing down. Do not be fooled into thinking this is cognitive decline, you have so much information in your brain that it takes more time to access it! You can be stronger and happier in your retirement than ever before. Life is an adventure, you can expect change and embrace it. Learn the right time to retire, how to boost your retirement income and create your dream retirement. Follow your dreams and love what you do!
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The Best Income Strategy Part 3