Below are some tips to focus your thoughts if you are planning to draw an income directly from your pension using the new pension freedoms.
1. Estimate how long you will live.
We are all living longer, the average 65-year-old man in the UK is now expected to live until 86 and women until 89. Tony Stenning, head of UK retail at BlackRock, says: “It’s important that baby boomers think very carefully about how they will sustain their income through a much longer retirement than previous generations.”
In the table below you can see you expected life expectancy if you have attained a certain age. It is based on historical mortality rates from 1981 to 2012 and assumed calendar year mortality rates from the 2012-based principal projections.
UNITED KINGDOM LIFE EXPECTANCY
| Attained age in 2015 (years) | Cohort life expectancy in years Males | Cohort life expectancy in years Females |
| 0 | 91.0 | 94.3 |
| 55 | 31.0 | 34.0 |
| 60 | 26.2 | 29.0 |
| 65 | 21.6 | 24.3 |
| 70 | 17.3 | 19.7 |
| 75 | 13.3 | 15.4 |
| 80 | 9.9 | 11.5 |
| 85 | 6.8 | 7.9 |
| 90 | 4.6 | 5.3 |
| 95 | 3.1 | 3.5 |
| 100 | 2.1 | 2.4 |
2. Decide what minimum annual income you can live on in retirement
Allow yourself to feel rich for all of 30 seconds and then accept that your pension savings will need to last you for 20, 30 or even 40 years. Identify your fixed living costs and then decide how much you need on top of paying for the bare essentials. The average cost of being a pensioner is £11,200 a year, according to research by Key Retirement. The cost adds up from spending on the basics including food, clothes, travel and heating with a weekly £215 needed per head, Key’s analysis of government figures on household expenditure shows.
You might find that you want to secure this minimum income using an index-linked annuity. Many wealthier investors will use annuities or defined-benefit pensions alongside an income drawdown strategy.
3. Divide your income pots into three
Ray Chinn, head of pensions at LV=, suggests that you have three pots of money for your retirement. The first pot is for essentials such as regular bills that have to be paid every month. A secure income from an annuity would fulfil this purpose, preferably rising in line with inflation. However, if you are in an income drawdown strategy you could hold two years income in cash as an ‘income tap’, making sure that you top this up with more income as you use it.
The second pot of money is your rainy day fund, for a boiler breakdown or other unexpected outlay. You could keep this in a cash individual savings account.
The other pot of money is for luxuries such as holidays and eating out and you can be more flexible with the investment strategy for this money. “You can put it a bit more in terms of chasing growth if you have already taken out an annuity for minimum income,” he says.
4. Treat retirement as a U-shape
Most commonly, there is a U shape to retirement income needs, made up of 3 stages. In the United States they call these the Go Go years, the Slow years and the No go years.
In the Go go years, typically ages 55-75 (although this will vary a lot) you might travel the world and spend lots of money on having a good social life. In the Slow years, typically 75 to 85, your income needs drop. In later life, many people need a higher income to pay for healthcare, or residential care. However, everyone’s U shape will be different.
5. When drawing down income you face greater risks if the market falls
Irreparable damage can be inflicted on our funds if we take 'heavy' withdrawals from investments that are shrinking in value due to stock market falls. Strong market recoveries are often not enough to recover our funds. Read more about this here.
One solution - to avoid encashing capital - is to take only the 'natural income' on our investments. The natural income is that generated by the underlying assets in our funds (dividends on shares, interest on deposits and fixed-interest securities and rent from any property), and it tends to be more stable than capital values.
6. Diversify your income sources
When you’re investing for income, you need to diversify your income sources as much as possible across asset classes and geographies. We see many investors who focus on the traditional UK income stocks such as BT, Vodafone and GlaxoSmithKline. There is nothing wrong with this approach but you also need overseas equity income exposure.
For example, you can get income from the US cheaply via an exchange traded fund such as the SPDR S&P US Dividend Aristocrats UCITS ETF (USDV). For more ideas for diversifying your income sources visit the Investors Chronicle's Top 100 Funds and Top 50 ETFs.
Read more
Pension freedom: Moira O'Neill explains the new pension rules coming into play in April.
