When planning your retirement and how to create an income from your pensions, there are several key things you need to consider:
Pensioners, and would-be retirees, are exposed to a number of different risks. Typically, when we talk about risk, we think about investments falling in value.
However, when considering your retirement income, there are other risks you need to consider:
- Annuity rate movements
- Longevity risk
- Investment risk
- A change to your personal circumstances
Over the past couple of years, inflation has never been far from the headlines and it remains a serious risk for pensioners, who often have fixed incomes, which inflation will erode. Of course, this reduces your spending power.
To put it another way, you will be able to buy less in the future than you can today, if the rate of increases attached to your investments, savings or retirement income does not match inflation.
This is a problem for people who buy Annuities, which rarely include indexation, due to the cost and large resulting reduction in the level of income at the outset.
To put the problem in context. If inflation remained at a constant 2% per annum, then the real value of a £10,000 income today would be £7,386 in 15 years; more than a 25% reduction in real terms.
Annuity rate movements
The timing of an Annuity purchase can have a big impact on the level of income available. Annuity rates are heavily linked to gilt yields, which fluctuate and can have a significant impact on the rate available from one month to the next.
Predicting Annuity rate trends, and therefore the timing of your purchase, is becoming increasingly difficult.
Several retirement income options allow you to defer the purchase of a Lifetime Annuity to a future date. Whilst these options provide much needed flexibility, there is a risk that when you eventually purchase an Annuity, rates may be lower than at present. Of course, the opposite could equally be true and you may find they are higher.
Longevity risk is effectively the risk of living too long and running out of money before you die.
Life expectancy has increased significantly over recent decades. According to the Office for National Statistics (ONS), the average life expectancy in the UK for a male currently aged 65 is a further 18 years, rising to 20 years for a female.
Some options described in this guide, such as a Lifetime Annuity, remove longevity risk, by promising to pay an income for the remainder of your life, and, where selected, that of your partner.
Other products leave you exposed to longevity risk and the potential of a depleted pension fund with several years of income still required.
In the worst cases, this will mean income levels are reduced significantly in later retirement. This risk is closely related to investment risk (see below), and can, to a degree, be managed through appropriate investment strategies.
Your own health is closely related to longevity risk. There can be some advantages gained by deferring a Lifetime Annuity until later in life, as life expectancy becomes more predictable. In addition, if your health worsens, it may be possible to take advantage of Enhanced Annuity rates rather than normal Lifetime Annuity rates.
Several of the options described later provide you with the opportunity to continue investing your pension pot for potential future growth. This means you will continue to expose your fund to your chosen level of investment risk.
It is possible to invest these funds in a manner designed to limit the downside of any economic turbulence. However, you will need to consider the level of return required to make such a plan a success. Typically, if you target higher returns, you will need to increase the level of risk you are taking.
This can mean there is potential for a higher upside, which is matched by the potential for a greater loss on the downside.
Some options, such as Fixed Term Annuities and Investment Linked Annuities, offer a facility to limit the downside of investment risk. This works by providing an underpin of either a minimum income, and/or a minimum fund value.
A change to your personal circumstances
Your circumstances have no doubt changed throughout your life and it is likely that they will continue to evolve. It’s important to consider how you see your retirement developing and the potential life changes that may occur.
Some options, such as a Lifetime Annuity, offer no future flexibility or possibility of change; others offer the opportunity to change at certain points in time; and some methods offer full flexibility.
Each option comes with its own set of risks and compromises may need to be made, to find the most suitable structure for you.
Questions to consider
Whether you are using a financial adviser to help plan your retirement, or you are going it alone, it’s vital you spend some time thinking about the goals and ambitions you have for the rest of your life.
We’ve pulled together a list of questions you might want to ask yourself to help identify exactly what is important to you in years to come:
- What does retirement mean to you?
- Do you want to stop working altogether, keep working as long as possible, or gradually reduce your working hours?
- Do you have a specific age in mind?
- Will you want to sell any assets, such as a business or a property?
How do you want to live in retirement?
- Are there any once in a lifetime dreams you want to fulfil?
- Do you have plans to move abroad, or purchase a second property?
- Do you anticipate living in your current house or downsizing?
- When will you need to generate retirement income and how much?
- Will you need your income monthly, quarterly or annually? Does it have to be paid on the same day?
How much risk can you afford to take with your income?
- How much do you spend on essential items each month, for example, council tax, utility bills, food etc?
- How much do you spend on discretionary items each month, for example holidays, birthdays and Christmas?
- Does it matter if your income falls? If so, by how much could it fall before you get in to financial difficulty?
- What other income sources or assets do you have available?
- How important is certainty of income, is there a minimum you need to meet?
How much risk do you feel comfortable with?
- Would you rather take some risk with this income, to see if you can get more, even if this means it may go down and you could lose it altogether?
- Is it important for you to retain flexibility, accepting this comes with some additional risk, or would you prefer to make an irreversible decision in return for greater certainty of income?
- Are you more concerned about the risk of inflation eroding the relative value of your money, or investment fluctuations eroding the absolute value of it?
- Are you comfortable with retaining an ongoing involvement in managing your retirement income, albeit with professional help, or would you rather make a decision and then forget about it?
Preparing for the worst
- How healthy are you? Do you have any illnesses or any concerns about how long you might live, or require income for?
- Do you have any future financial obligations to meet, such as debts?
- Do you have dependents, such as family, who would be reliant on your income when you die?
- Do you wish to leave an inheritance?
- Should you need specialist care in later life, do you have any views on what type of care you would prefer?
Pensions Freedom – A summary of the key changes
Pensions Freedom – Key questions answered
Delay taking your pension
Investment Linked Annuity
Fixed Term Annuity
Uncrystallised Funds Pension Lump Sum (UFPLS)
Purchased Life Annuities
8 Steps to take leading up to retirement