For any readers approaching or over the age of 60, the topic of how best to take a pension starts to loom large on the horizon. This is the age when the decisions of the past start to catch up with you, and where the decisions you make now have a crucial impact on retirement income.
Education about the facts of pension life is still inadequate, despite the best efforts of providers and regulators. One factor is an element of self-delusion on the part of some would-be pensioners. Common mistakes are to save too little, and to begin saving too late, perhaps relying on the possibility of using their property as a source of pension capital. Banking on an inheritance from a parent or elderly relative can also be a big mistake, when a combination of care-home costs and increased longevity come into play.
Overestimating what a pension fund will buy, in terms of regular income, is another common error. Monthly contributions into a personal pension need to be on the verge of being painful to have a chance of yielding a worthwhile fund on retirement.
The next mistake is not doing sufficient research on how to maximise the pension value of the fund you do have. Most retirees simply use their pension fund to secure an annuity at the time they retire. Typically, they take the quotation offered by the insurance company they deal with.
That's often not the best option, especially for individuals who may be considering continuing with paid part-time work or those who are perhaps winding down a business. But even for others, simply exploring the so-called 'open market option' can result in a significant uplift in pension income.
Put simply, rather than accept the quotation they are fed, annuity buyers can take their pension pot to another provider and explore whether a better deal is available. Annuity rates vary hugely from insurance company to insurance company. Life companies that don't want new annuity business will tailor their rates to discourage it, and vice versa. Equally, those with health problems or bad habits might find they qualify for an impaired life annuity. This pays out more income because the insurance company expects your life expectancy to be shorter.
Drawing down income
Income drawdown, in existence since 1995, has been widely publicised as an alternative to an annuity. It is, however, still only taken up by a small number of retirees. In terms of assets invested it is more prominent, probably representing around one-third of the 'at retirement' pensions market. "There is still a fundamental need for education about drawdown as a concept," notes Nick Blayden, head of marketing development at Skandia.
Drawdown has the big advantage of retaining flexibility, although at the expense of running additional risks. The tax-free lump sum that everyone is allowed to draw from their pension fund can be taken at the outset. This is normally 25 per cent of the fund's value. But with drawdown, rather than buying an annuity, the remaining fund is left invested and as much or as little income taken from it each year as required, subject to a limit handed down by the Government Actuary's Department in conjunction with HM Revenue & Customs.
Broadly speaking, the upper limit of what can be drawn down each year is influenced by gilt redemption yields and by an individual's age. As a rule of thumb, the yield on a 15-year gilt will approximate to the return used as the basis for the calculation. In effect, the end result will amount to roughly 120 per cent of what a single life (as opposed to joint life) level annuity would pay for someone of that age. The maximum amount available increases, other things being equal, as a plan holder gets older.
So, where's the risk? Lower gilt yields will produce less income, as will – because the fund remains invested – a drop in the value of the underlying pension fund. It is the interplay of these factors that determines the retirement income that is available. The basis of calculation, and therefore the allowable income available, is lower for women than for men. Another factor is that drawdown investors have to consider whether taking the maximum allowable drawdown income might unduly deplete their fund. One source estimates, for example, that only at a withdrawal rate of 4 per cent a year can a fund's value be broadly maintained over time, assuming average investment returns.
The main advantages of a drawdown scheme are that the individual retains the flexibility over how much income to take, and how it is to be paid, and indeed whether or not to continue paying into the fund. The amount taken out of the fund can be varied year by year. Control is retained over the investment policy of the fund. And, equally, unlike annuities (except in the case of a joint life annuity) there is a range of death benefits that allows the undrawn residue of the fund to remain intact and perhaps be passed on at a later date. In the case of individuals with other investments they may be wanting to draw on at retirement, a scheme of this sort allows for considerable flexibility in determining the sequence in which assets are used to fund retirement income needs.
But there are disadvantages, too. The main one is that there is a risk that the value of the fund could go down as well as up. This argues for the fund to be invested in a conservative manner, albeit not to the point of simply replicating the returns one might get from an annuity. Delaying purchasing an annuity can also end up being a worse deal. Annuity rates may go down, in which case a delayer would have to earn a higher return than they would be forgoing in an annuity just to end up all square.
The importance of investment options
Even being helped along by an IFA, the administrative details of setting up a drawdown plan can be off-putting. You may, for example, wish to transfer your pension fund from the existing provider. Details vary from company to company, but one crucial factor – if you wish to manage the fund actively – is to make sure that the drawdown plan provider you choose offers as broad a choice of investment funds as possible in which to invest it.
Some traditional insurance companies, for example, offer a very restricted range of funds; others, in one way or another, encompass more or less the whole universe of funds. Charges also differ considerably. Some companies offer both a restricted choice of in-house funds, and also have higher charges. Minimising charges helps to cut down on any drain in capital that could be used to add to your pension income.
Transferring from one insurance company to another for drawdown purposes can sometimes be a lengthy and convoluted process. In some cases the transfer might need to be made from one pension fund plan with company A to a similar one with company B in the first instance, and then a further transfer made within company B from a normal pension plan to a drawdown scheme (often called a Personal Pension Income Plan). It is at this point that the tax-free lump sum will be released. "Most of the procedures are governed by statute," says Mr Butt. "They are there to protect people. These are big decisions and it wouldn't be right to make them too easy."
Many pension providers are, however, now offering one-stop-shop policies for new investors that allow for a switch to be made at retirement to a drawdown scheme within the same plan with rather less effort.
One point to bear in mind concerns pension funds invested in a with-profits fund. Transferring at the time of notional retirement triggers payment of a terminal bonus. That bonus may, however, not be the last published one, and if you transfer after a sizeable market setback, it could be less than you expect to get.
Transferring unit-linked with-profits funds could also in theory result in a market value adjustment (MVA) being made, although this should be waived if the individual in question is over retirement age and the exercise is part of a wider retirement income planning strategy.
If the transfer is being made to a new plan within the same company, in some instances it can be made in 'specie' – that's to say the fund holdings transferred untouched into the new plan – in which case no disposal has taken place and no MVA should be levied. But the detail needs checking and confirmation received in writing that no MVA will be charged.
Finally, if your plan is with a company with a recognised fund platform – such as Skandia and Standard Life – it is easy to check on the progress of your fund or funds online. Skandia, for example, has a password-protected secure UK client extranet within its website where the overall value of a plan and the performance of its individual components can be checked on a daily basis, and switches within the portfolio done online.
That's part and parcel of Skandia's view that the old definition of retirement needs to be changed, away from one that is defined in terms of stopping full-time work. According to Skandia's Mr Blayden: "We all have to overcome the old way of thinking about this. Retirement now is simply when you start needing access to your pension capital and the potential income it can generate."