One of the biggest concerns I hear from people about retirement is how to turn pension savings into income. When I were a lad there were final salary pensions for the lucky few with everyone else more or less compelled to acquire an annuity, if indeed they had any pension provision at all.
Whilst this wasn’t an especially flexible state of affairs, it did have the virtue of simplicity. It meant that people didn’t need to think too deeply about their pensions if they didn’t want to. For sure the financial outcome was often less than ideal, but the relative lack of interface with the financial system suited many people just fine. Somewhat depressingly though, even as people were encouraged to shop around for the best annuity deal, as recently as 2010, a depressing two-thirds purchased their annuities from their existing pension provider.
Against that sort of backdrop it isn’t hard to imagine that the recently announced pension freedoms will actually cause some people considerable stress. Previously the decision was largely taken out of your hands so there wasn’t quite the same scope to “regret” your choice once you were committed.
Next year, however, imminent retirees will be painfully aware that the path of least resistance, an annuity, is very likely not their best option. At the same time though, they will be faced with the responsibility of how best to provide themselves with a pension for life from their savings: a weighty burden.
So what are the investment issues?
First up, the new freedoms change the investment horizon. Previously someone just a year from retirement, and the associated annuity purchase, would be extremely risk averse. They would be looking to protect their fund from an unfortunate, last minute slide in either investment valuations or annuity rates. However, while an essentially zero return is fair enough over a few months, or even a year, the average length of retirement is already close to 20 years, which is an altogether different proposition.
This brings us to the second issue, that of investment returns. With responsibility for the investment of what, even for those with relatively small pension pots, is still a large sum in nominal terms, zero returns over a period of two decades are both unconscionable and impractical.
The problem is that those with the smallest pots, and thus those in most need of strong investment returns, are precisely those who cannot afford the risk of a significant loss. For them the attraction of a guaranteed annuity is likely to be proportionately greater, than for someone who is less risk averse.
For people with greater resources, and therefore more flexibility, the option to increase the weighting towards riskier assets increases pretty much exponentially. As alluded to above, this though brings with it the bewildering prospect of how to invest a considerable sum of money for both income and capital appreciation, which is the third issue.
In the past this was usually a fairly straightforward choice between bonds that pay a fixed, but generally low, coupon and equities which offer a variable, but potentially greater, return: or some combination of the two.
However, next year’s pension freedoms will significantly change things. For a start, it will shortly be theoretically possible to withdraw your entire pension at 55 and invest it (or spend it) outside the traditional suite of pension products. It is already possible to invest more liberally within a SIPP (self-invested personal pension) or a SSAS (small self-administered scheme), but there are still constraints and total withdrawal is currently a costly option from a tax perspective.
However, relieved of the punishing 55% tax exit fee, some people are intending to withdraw their entire pension pot next year and many appear intent on investing heavily in property.
Whilst I am hardly in a position to counsel against property as an investment, being a landlord myself, there are at least three serious issues that have to be considered first.
1) Tax. While the 55% Death Tax or Pension Withdrawal Tax is set to be scrapped next year, pension income is nevertheless treated as taxable income, less the 25% tax-free cash sum if applicable.
Thus to withdraw £200,000 from a pension to fund a property investment, even assuming no other income is taken or earned in that year, will cost £49,627.
This is made up as follows:
£50,000 Tax Free Cash Sum
£10,000 Personal Allowance
£31,865 Taxed at the basic rate of 20% £6,373
£108,135 Taxed at the higher rate of 40% £43,254
Grand Total £49,627
This actually slightly understates the tax owing as, for simplicity’s sake, I have ignored the fact the the personal allowance is progressively withdrawn for those earning in excess of £100,000.
2) Illiquidity. While property may yield an income, it is not certain (voids, costs etc) and your capital isn’t easily available for drawdown.
3) Returns. Contrary to popular belief, buy-to-let investing isn’t generally a massively profitable undertaking. If it were then many more developers would be building properties specifically to let, rather than selling them on to release their capital. At the same time, the major source of property investment return for moms and pops is capital appreciation, not rental cash flow. However, paper profits can only safely be realised by selling the property and, even then, you’ll very likely generate a capital gains tax liability.
The higher returns come from gearing, which is jargon for having a mortgage. This not only makes your cash go further, but the mortgage interest is also tax deductible. Someone investing purely for pension income though will very likely not have a mortgage, which will help in terms of cash-flow, but cuts the return on assets employment (i.e. your net rental income compared to your equity in the problem). Either way though, investors will still need to do their own research to make sure the numbers stack up and that they have a viable business proposition.
I’ll revisit the subject of property as a pension investment in the near future as I know that many of you are interested. More generally though you can see that the new pension freedoms present people with some very considerable challenges in areas which many have traditionally shied away from. This is compounded by the advice gap I highlighted in an earlier post, whereby those with less than £250,000 of investable assets can sometimes find it difficult to get expert financial advice at any price.
Take care out there