As I sit here, as a late 40 year old, writing this post 41% of my wealth is held within pension wrappers including a very healthy SIPP. If I stay the course with my Investment Strategy then Early Retirement will likely appear around age 44. Running a forecast to that age, which looks at my intended contribution profile and expected portfolio diversification into both the pension and non-pension assets, would result in 44% of my wealth being within pensions at that point. This is of course only going to be true if the my investments perform on average over that period which of course is a big if but is all I have to use for forecasting.
If I then continue with the Transition to Retirement Strategy which includes the purchase of a home for my family and includes rapid pay down of the mortgage in the 11 or so years until I can access my pension assets then my pension wealth will rise quickly as a percentage of total wealth. This is because my non-pension assets will need to generate my salary as well as pay down the mortgage while the pension continues to grow in value from investment return. To demonstrate the severity of this if I step my retirement forward 10 years to age 54 my pension wealth could be as high as 83% of my total wealth. This excludes any equity which I will have in the family home which might frustrate The Investor over at the excellent Monevator somewhat. That’s a lot of wealth tied up in a wrapper that has a track record of being tinkered with by government. What’s also interesting is that as I leave the early retirement phase of my life and become a typical retiree my position is probably not that much different to most people who have saved in a pension for a typical retirement.
Step forward 1 year to 55 and it all gets interesting, at least under current pension rules, as I can now start to access my pensions. The no brainer for me is that I’ll firstly take the 25% tax free lump which in line with the Transition to Retirement Strategy will be used to pay off the mortgage, maximise that years ISA contribution and invest the remainder as tax efficiently as possible. At that point my forecast suggests around 75% of my total wealth is now within the pension.
Unless I’ve missed a trick I believe I now have essentially two options if I want to generate an income from the remaining pension pot. I can put the pension into Income Drawdown or alternatively buy an Annuity. Let’s look at the Pro’s and Con’s of each option plus run an example for each option based on my situation assuming I was 55 today.
The wealth contained within the pension that is under income drawdown remains invested in your chosen asset classes. It therefore sees gains or losses in line with those market moves.
If you’re prepared to be DIY including the risks that go with that and have a decent pension pot then you can run a low expense income drawdown strategy.
In the event of death your husband/wife, civil partner or dependents can normally continue with the drawdown income. Alternatively they can choose to buy an annuity or even take the wealth as a lump sum where they would be hit with a 55% tax charge.
It gives the opportunity to delay annuity purchase which may allow annuity rates to improve as you age.
The wealth contained within the pension that is under income drawdown remains invested in your chosen asset classes. It therefore sees gains or losses in line with those market moves.
It gives the opportunity to delay annuity purchase which may result in a worse annuity rate as you age because of market factors.
Finally, the big elephant in the room. There is no “insurance” that protects you from asset depletion should you take more income than investment performance less expenses can support.
Purchasing an annuity moves you away from the meddling that could and IMHO is likely to continue to occur with pensions.
If you have health issues then a higher annuity level may be possible by heading for an impaired life annuity.
Those with larger pension pots could consider a phased annuity purchase which is run in conjunction with Income Drawdown.
There is no portfolio maintenance or investing effort required. You can simply go fishing and the income lands in your bank account at agreed intervals. This is something I’m very conscious of. As a 41 year old I feel my mind is still very sharp. When I turn 55 I’d be willing to bet I’ll still be ok but I wouldn’t be willing to bet that will be the case when I’m 85. An annuity would take that risk away.
Annuities rely on people having varying life expectancies. Die the day after you start the annuity and the house wins (unless you choose guarantee periods, value protection, dependent options etc which partially offset this risk but will result in a lower annuity amount to compensate for it) and you end up with nothing however live to 120 and it’s likely you’re onto a good thing. This could therefore be both a Pro and a Con. This is the opposite of Income Drawdown where time can be your enemy as every year you live gives a higher risk of wealth depletion.
It’s a one time bet. Get the type of annuity wrong or buy it at the wrong time and you have to live with the decision for the rest of your life.
There is a cost associated with all that certainty and “insurance”. Additionally there are no DIY annuity options that I am aware of meaning there will be expense drag because of this also.
As a 41 year old there are still many years for the rules of Pension, Annuities and Income Drawdown to change. Additionally gilt yields and other relevant market forces are sure to be different which will result in different annuity rates and chances of Income Drawdown success for a given SWR. There is therefore no value in me deciding whether I’ll go the Annuity, Income Drawdown or even a hybrid variant at this time. For now I’ll just continue to Save Hard and Invest Wisely to provide that Early Retirement.
Can you think of any more Pro’s or Con’s of Annuities and Income Drawdown? Have you already made a decision on buying Annuity or entering into Income Drawdown on your pension? As always I’d value your thoughts.
... and finally please always DYOR.
If I then continue with the Transition to Retirement Strategy which includes the purchase of a home for my family and includes rapid pay down of the mortgage in the 11 or so years until I can access my pension assets then my pension wealth will rise quickly as a percentage of total wealth. This is because my non-pension assets will need to generate my salary as well as pay down the mortgage while the pension continues to grow in value from investment return. To demonstrate the severity of this if I step my retirement forward 10 years to age 54 my pension wealth could be as high as 83% of my total wealth. This excludes any equity which I will have in the family home which might frustrate The Investor over at the excellent Monevator somewhat. That’s a lot of wealth tied up in a wrapper that has a track record of being tinkered with by government. What’s also interesting is that as I leave the early retirement phase of my life and become a typical retiree my position is probably not that much different to most people who have saved in a pension for a typical retirement.
Step forward 1 year to 55 and it all gets interesting, at least under current pension rules, as I can now start to access my pensions. The no brainer for me is that I’ll firstly take the 25% tax free lump which in line with the Transition to Retirement Strategy will be used to pay off the mortgage, maximise that years ISA contribution and invest the remainder as tax efficiently as possible. At that point my forecast suggests around 75% of my total wealth is now within the pension.
Unless I’ve missed a trick I believe I now have essentially two options if I want to generate an income from the remaining pension pot. I can put the pension into Income Drawdown or alternatively buy an Annuity. Let’s look at the Pro’s and Con’s of each option plus run an example for each option based on my situation assuming I was 55 today.
Pro’s of Income Drawdown:
Income payments can be varied to suit your needs. If you have a secure pension income of at least £20,000 per year elsewhere then that annual income amount is unlimited as you’ll be operating within the Flexible Drawdown rules. If, like me, you won’t have a secure pension income of £20,000 then you will be operating under the Capped Drawdown which sets an annual income limit depending on the yield on 15 year UK Gilts and your age. So what would that capped drawdown income limit be for me assuming I was 55 today and looking to go into Income Drawdown? With the yield on 15 year UK gilts at 2.9% as of the 15 July 2013, the GAD tables would allow a 55 year male to withdraw 4.6%. On the 26 March 2013 the annual maximum income allowance available under drawdown increased from 100% to 120% of the applicable GAD maximum income limit. This means my maximum withdrawal would move from 4.6% of pension wealth to 5.5% under current rules.The wealth contained within the pension that is under income drawdown remains invested in your chosen asset classes. It therefore sees gains or losses in line with those market moves.
If you’re prepared to be DIY including the risks that go with that and have a decent pension pot then you can run a low expense income drawdown strategy.
In the event of death your husband/wife, civil partner or dependents can normally continue with the drawdown income. Alternatively they can choose to buy an annuity or even take the wealth as a lump sum where they would be hit with a 55% tax charge.
It gives the opportunity to delay annuity purchase which may allow annuity rates to improve as you age.
Con’s of Income Drawdown:
If you’re not confident or knowledgeable enough to go DIY, don’t want to waste time/effort undertaking regular reviews or simply lose the ability to do these things as you age then you need to factor in the cost of financial advice which can place a big drag on performance after expenses are included.The wealth contained within the pension that is under income drawdown remains invested in your chosen asset classes. It therefore sees gains or losses in line with those market moves.
It gives the opportunity to delay annuity purchase which may result in a worse annuity rate as you age because of market factors.
Finally, the big elephant in the room. There is no “insurance” that protects you from asset depletion should you take more income than investment performance less expenses can support.
Example of Income Drawdown:
By taking 5.5% Income Drawdown per annum from the pension at age 55 I could be both saving a portion of it into my ISA, while taking little to none from my non-pension wealth and still generate my required income from my total wealth. With time this will result in the percentage of my wealth being held within the pension reducing thus reducing pension risk. This is all possible because I would never be spending 5.5% of my total wealth as wealth depletion would be a real concern at this level. Instead I’ll be selecting a safe withdrawal rate (SWR) which better balances risk of depletion vs maximising income. I’m going to be cautious here as with Income Drawdown I’m very conscious that I carry all the risk. I’ve covered SWR’s in detail previously and while there is no value in me stating what my chosen SWR is planned to be, I will say it is going to be less than 4%, which in many circles is considered the rule of thumb, particularly when I consider our end of 2006 retiree who entered Income Drawdown. After all if I get it wrong I’m dependent on the State which is fast running out of other people’s money.Pro’s of an Annuity Purchase:
I think of annuities as a form of “insurance”. For example a lifetime annuity gives a guaranteed income for life. Once purchased its not dependent on personal circumstances, doesn’t carry the risks inherent in income drawdown and provided you don’t choose one which is investment linked doesn’t typically carry investment risk.Purchasing an annuity moves you away from the meddling that could and IMHO is likely to continue to occur with pensions.
If you have health issues then a higher annuity level may be possible by heading for an impaired life annuity.
Those with larger pension pots could consider a phased annuity purchase which is run in conjunction with Income Drawdown.
There is no portfolio maintenance or investing effort required. You can simply go fishing and the income lands in your bank account at agreed intervals. This is something I’m very conscious of. As a 41 year old I feel my mind is still very sharp. When I turn 55 I’d be willing to bet I’ll still be ok but I wouldn’t be willing to bet that will be the case when I’m 85. An annuity would take that risk away.
Annuities rely on people having varying life expectancies. Die the day after you start the annuity and the house wins (unless you choose guarantee periods, value protection, dependent options etc which partially offset this risk but will result in a lower annuity amount to compensate for it) and you end up with nothing however live to 120 and it’s likely you’re onto a good thing. This could therefore be both a Pro and a Con. This is the opposite of Income Drawdown where time can be your enemy as every year you live gives a higher risk of wealth depletion.
Con’s of an Annuity Purchase:
If you choose a level annuity then inflation is of course a risk but some annuities also allow you to partially offset this risk.It’s a one time bet. Get the type of annuity wrong or buy it at the wrong time and you have to live with the decision for the rest of your life.
There is a cost associated with all that certainty and “insurance”. Additionally there are no DIY annuity options that I am aware of meaning there will be expense drag because of this also.
Example of an Annuity Purchase:
Regular readers will know the damage that inflation can do to spending power. Therefore personally I think I’d be looking for an annuity with some inflation protection. (Note: I may sway on this dependent on how life pans out because by not inflation proofing I will end up with more income now at the expense of less later on as inflation erodes the value of the £. I just can’t help but think that a 55 year is going to be looking for more annual income than a 90 year old.) As with Income Drawdown I’d also be looking for some income protection for my better half. This is because even though she also has her own wealth I’m conscious that it is not half as expensive for one person to live as two. Assuming I was 55 today and running some simulations on the annuity calculator at My Pension Expert, which enables you to get some quick market quotes, I find that the best Joint Escalating Guaranteed Annuity which has a 5 year guaranteed payment period and would also provide my better half with 50% of the annuity income should I die first (after all there is always a risk I could be hit by a bus the day after I retire), includes an income rise each year in line with inflation (RPI) up to a maximum of 3% per year would provide an initial income that equates to about 2.1% of my invested wealth. I think of this as effectively a “2.1% SWR” albeit with different levels of certainty.As a 41 year old there are still many years for the rules of Pension, Annuities and Income Drawdown to change. Additionally gilt yields and other relevant market forces are sure to be different which will result in different annuity rates and chances of Income Drawdown success for a given SWR. There is therefore no value in me deciding whether I’ll go the Annuity, Income Drawdown or even a hybrid variant at this time. For now I’ll just continue to Save Hard and Invest Wisely to provide that Early Retirement.
Can you think of any more Pro’s or Con’s of Annuities and Income Drawdown? Have you already made a decision on buying Annuity or entering into Income Drawdown on your pension? As always I’d value your thoughts.
... and finally please always DYOR.
If you were to invest heavily now in long ILGs (the 2044s?) then you would be hedging the cost of an index-linked annuity when you are 55 because the ups and downs of ILGs that still had a twenty year life would mirror the down and ups of IL annuity rates. This is liability-based investing - you'd be saying "I am going to buy an annuity of that style, at that time, of such and such a size, so I will invest a large enough chunk to ensure that I can do so".
ReplyDeleteWhat's left over you could put into equities and gold, say.
Hi dearieme
DeleteThanks again for a well reasoned response. As always you seem to provide an angle or food for thought which I hadn't even considered. Would you ever consider writing a Guest Post that detailed your own investment portfolio, strategy or musings? I ask because it would likely shed a very different light to that which I detail here regularly. I believe this could only beneficial to readers and myself. If you'd be interested feel free to email me at contact [dot] retirementinvesting [at] googlemail [dot] com.
Cheers
RIT
It's kind of you to ask, but probably "no, thanks"; or at least "not yet". Yeah, maybe "not yet".
DeleteMy comment above had two implications. (i) Golly it's costly to try to fund a future decent income from an index-linked annuity for a 55-year old by buying ILGs now. (ii) Yet it's risky to try to fund that proposed annuity by investing in equities now, when you have less than the ideal twenty to thirty year horizon, and equities (at least on Wall St) are poor value.
I suppose in your shoes I'd expect to use drawdown and defer buying an annuity for a decade or two. Or wait until ILGs are better value: but their value is artificially depressed by buying by banks, insurance cos and pension funds, who all have to meet government-imposed requirements to own them, so there's no particular likelihood of their becoming much better value in the near future. In fact ILGs are such poor value that I'm contemplating buying TIPS in our ISAs - which would have to be done by way of an ETF. But I know nothing about such ETFs and their tax positions, so I have cold feet at the moment.
Personally I fear that the Great Debt Crisis has nowhere near run its course and that further horrors may not be far off. So we've bought gold ETFs. If I had access to a decent safety deposit we would instead have bought gold sovereigns. At our ages a bit of insurance is welcome.
No problem. If you ever change your mind then feel free to drop me a quick email.
DeleteAs I mentioned in the Transition to Retirement post from where I sit today if I was forced into making a choice given my + current circumstances I'd probably follow your hypothesis. Enter Income Drawdown then watch annuities carefully.
Funny you mention gold ETF's and gold sovereigns. That's the topic of today's post.
"their value is artificially depressed": ach, I meant that their yield is artificially depressed - their value is artificially raised.
DeleteWhat about fixed term annuities?
ReplyDeleteThe benefit there is most of the payment is treated as return of capital and therefore tax free. You only pay tax on the earned interest component.
A lifetime annuity you pay tax on the entire amount.
Would this not be a better approach?
This is what Im thinking, but have not yet done the final sums. But most fixed term annuities offer about a 5% return component. Not far off what lifetime ones do IIRC.
In effect a lifetime annuity is based on standard life expectancy. So you only win if you live over the average. You could buy a fixed term annuity to take you to say 1 or 2 standard deviations past your expected lifespan and perhaps still be better off due to the tax treatment.
I must admit Ive not done the sums yet, but it may be the better way to go.
There are life expectancy calculators around which will give you a good idea. So why pay someone else all the margin and overheads to do this? Surely better than to manage this yourself and perhaps end up with some capital left at the end as a failsafe margin.
Finally what's the difference between all the above and just buying some long term Index or nominal Gilts and running them down according to a sliding table? The only challenge is setting up the mechanism so that you just get £x in the bank each month.
Why spend so much time and effort controlling costs on the saving for retirement side then accept the full force of fee's at the retirement end? There seems to be an equal opportunity to slash costs heavily at that end too.
I think you should cast your sharp mind around some more :)
Hi ClubsportR8 and welcome to RIT.com
DeleteThanks for the suggestion. Something new for me to go and research. As regular readers well know I claim to be no expert and am learning just like all of this sites regular readers.
"Why spend so much time and effort controlling costs on the saving for retirement side then accept the full force of fee's at the retirement end? There seems to be an equal opportunity to slash costs heavily at that end too." Minimising fees and expenses is definitely one of my Invest Wisely mantra's and it's something I definitely intend to do in retirement as well as in the lead up to retirement. You'll have noticed I highlighted expenses as a con under the Annuity route as they are certainly an issue.
"I think you should cast your sharp mind around some more :)" That's exactly one of the reasons I started this site. There are a lot of sites out there with vested interests making it sometimes difficult to choose the right route. Hopefully you've seen that this site is not one of those. My hope is that by detailing my learnings (as I've done above) then what you've just done will occur. That is a well reasoned response with some alternative viewpoints. With this information I (and readers) can then go off and do more of our own research. I only wish that more readers would delurk (is that a word?) and share their experiences in the Comments. It would be even better if some healthy discussion were to then ensue between readers. RIT.com would then be a Community of sorts.
Cheers
RIT
RIT,
ReplyDeleteAs you conclude, it will be many years before you have to make the decision. In the intervening years, many aspects are likely to change. As we continue to live longer, I would not be surprised if the government had a look at the starting age of 55 yrs - maybe look to move it to 60?
I looked into exactly the options you outline last year and, tbh it was a no-brainer - the option of income drawdown was the better option for my situation.
In recent months, I believe annuity rates have improved a little but for the reasonably intelligent diy investor, I think drawdown will still provide a better average return than an inflation linked escalating annuity.
Earlier this year I published 'DIY Pensions' (ebook) which looks at these issues in some detail.
Hi John
DeleteGreat to hear from you. I must admit that when I received your EBook I read it from cover to cover over a couple of cups of tea. Most informative. I still have it referenced under the "Books That Helped Me" tab directly below the site banner.
Cheers
RIT
Hello RIT,
ReplyDeleteI'm wondering if you are mixing the two ebooks? The one you reference is 'Slow & Steady Steps..'.
Not sure if you have 'DIY Pensions' but if not would be more than happy to send it for possible review.
Cheers,
John
Apologies John. I thought I had both referenced above. I'll look to correct that on the weekend. I have however read both and did give DIY Pensions a brief review here for any readers who are interested.
DeleteI am puzzled at the proposal to use the PCLS to pay down your mortgage. First the disclaimer - I paid down my mortgage well before leaving work so I'm not eating my own dog food here. I was also more desperate to get rid of the wage slavery and craved security. Owning the means of production gives that security, but it means I have less working capital at this stage and have to hold large amounts of cash against emergencies which is depreciating rapidly...
ReplyDeleteBut you are a less emotional and more analytical investor. Does not that humungous and relatively low interest (appreciated we don't know where interest rates are going in 15 years) loan strike you as a massive opportunity cost if you pay it down? Heck, even if you keep it in an offset mortgage product where the savings are your emergency fund? Although the real value of your emergency fund would be being depreciated, so would the real value of the associated loan, and you largely eliminate the interest costs.
Alternatively you could do a Monevator and invest the capital, I didn't have the taste for that sort of derring-do but again, a more detached and rational investor might well do; after all a S&S ISA is one accepted way of saving to pay down the capital on interest-only mortgages.
People are often in such a great hurry to use the PCLS to discharge the mortgage. I'm going to invest mine to give me a bigger and UK tax-free (okay 10% pre-taxed) income.
Hi Ermine
DeleteI covered the rationale in some detail in the Transition to Retirement post but to expand on that. In short it seems like a sensible approach when I consider available opportunities to minimise tax resulting in more money in my pocket.
Prior to retirement (read prior to circa age 44) I want to maximise my ISA contributions, given their use it or lose it status, while also maximising my pension contributions. As a 40% tax payer now and a 20% tax payer in retirement the lure of pensions is strong. Paying down the mortgage at this point, particularly if it's a low interest 10 year fix or similar, doesn't seem to give me the best return for my situation.
In the early stages of retirement (read prior to age 55) I can't access my sizeable pension pot but need to live off my wealth. I need to make sure I won't run out of non-pension/non-ISA wealth while at the same time continually adding to the ISA. Again, because of its use it or lose it status.
Now I hit 55. Oh have I said I hate debt and want to be rid of it as soon as possible (emotional and very unlike me I know). I have access to a sizeable portion of non-taxed wealth which other than filling the ISA that year can't really be invested tax efficiently. Good bye mortgage.
Cheers
RIT
One aspect of an annuity is that the internal costs are surely high - more than the 0.5% or less that a disciplined passive index investor can achieve. For this reason alone it is probably worth avoiding 'over-annuitising', if that makes sense.
ReplyDeleteThe only purpose of an annuity is as an insurance against two risks. The risk of living too long and the risk of suffering an unfavourable sequence of investment returns shortly after retiring. My plan would be to estimate a low minimum manageble income and perhaps annuitise that and use draw down for the rest.
I find the decision about inflation protected vs non-inflation protected annuities very difficult. Remembering the 70's and how my initially quite well-off grandparents struggled with inflation and being fairly cautious, my first inclination is towards inflation protection. The trouble is that the costs are very high and the 'break even' age can be 15 years after retirement (depends on the actual inflation rate obviously). I haven't decided yet but a compromise might be to inflation protect 30-50% of the annuitised income.
There are so many uncertainties about the decision and of course the major uncertainty is that we might not make it as far as or very long past retirement age. Carpe Diem!!