If you're using income drawdown to get your pension, or you are considering it, then welcome to our new series, How to Invest Your Pension For Income. We walk you through what investments to choose, how much income to take, and provide a safety checklist for investors with different amounts of money to invest.
Here we explore how someone can turn a £100,000 pension pot into a steady income stream for the rest of their life.
Choose an investment strategy
Someone with £100,000 invested for income they need to live on would normally be advised to invest relatively cautiously. Financial planners recommend typical drawdown portfolios of this size should contain around 40-60 per cent equities, 30-50 per cent bonds, and 5-10 per cent commercial property for diversification. Generally, the older you are, within this investment range, the lower your equity weighting should be.
A lump sum of £100,000 sounds like a lot of money but if you're relying on it for sustainable retirement income, it's a relatively small amount of money. For this reason, it's wise to keep investment costs down by opting for some passive investments in your portfolio. James Sumpter, financial planning director at Bestinvest, says core exposures such as the US and the UK are sensible regions in which to use an exchange traded fund (ETF) or a tracker fund, because the market values in these regions are already relatively high.
He also recommends keeping one to two years' expenditure (£6,000-£8,000) in cash as an emergency fund to guard against tough years in the stock market in which your investments could suffer.
How much income should you take?
When investing it's useful to use the income you could get from an annuity as a benchmark. A 65-year-old male with a £100,000 pension could get £3,056 a year with a retail prices index (RPI) inflation link and spouse's benefits, but if you smoke, are much older, or are in ill health you could get much more.
Mr Sumpter advises most people with £100,000 invested not to take more than £4,000 a year in income, if they want to be confident that their pot will last them until they die. He plans his cash-flow models until age 100 on the basis that "life expectancies are rising and rising, and the longer you live, the more money you will need. We expect most people aged 65 now to live well into their 80s and early 90s, but it's better to be cautious than run out of money."
Aside from the potential for a bigger income and greater flexibility over income taken, one of the big advantages of investing your pension yourself over buying an annuity is that you can preserve all or some of your pot, so you can leave it behind to loved ones. Striking a balance that works between the two is one of the trickiest aspects of income drawdown. Bestinvest research done for Investors Chronicle shows how small adjustments to income and investment returns can lead to a very different retirement for someone with a £100,000 pension.
The research is based on the following assumptions:
• Pension pot: £100,000
• Individual savings account: £50,000
• Age 65
• Full state pension: £5,881 a year
• Withdrawing 4 per cent of the value of the pension and Isa each year, totalling £6,000 in year one.
To take a 4 per cent income from your pot (giving a total annual income of £11,881) and keep its value at £100,000, your portfolio would have to produce a 4 per cent real return (above inflation) every year. In nominal terms, if inflation averages 3 per cent over the next 35 years, Bestinvest calculates the underlying pension capital would actually have to increase from £100,000 to £281,000 to maintain its value.
If you do manage a 4 per cent real return from your investments, you could take a much higher income in the early years - say 8 per cent (which would give you around £17,500 in the first year) - and while your income and pot size would fall from there, you'd still have just over £10,000 a year at the age of 90.
Conversely, if the investments simply bob along in line with inflation, but you take a 4 per cent income from them, the value of your pot will quickly deteriorate, and your income along with it. By the time the retiree has reached 75 their income will have dropped from £11,881 to below £10,000, while their capital will have fallen by £50,000. If they reach the age of 90, they will have just over £7,000 a year to live on - unless they want to risk their pot running out completely. If the portfolio makes a 2 per cent real return the retiree would have around £8,500 a year to live on in their 90th year.
What kind of return is realistic?
Equities have averaged a 5 per cent real return with gilts delivering around 2.5 per cent over the long term (10 years plus). Past performance is no guide to future returns, but if past history is repeated, a portfolio of equities and gilts may be expected to deliver 3-4 per cent above inflation.
Safety Checklist
• Choose a DIY investment broker with low platform costs and choose funds with reasonable management fees to keep costs down.
• Consider using passive funds in your portfolio to keep the cost of investing low.
• Keep one to two years' expenditure in cash as an emergency fund to guard against tough years in the stock market in which your investments could suffer.
• Review your portfolio every six months and take stock of how much income you are taking compared with the return on your portfolio.
• If a large chunk of your income is coming from your state pension, make sure you are getting any additional benefits you are entitled to such as a free bus pass and TV licence.
Income vs savings for someone with £100,000 in a Sipp and £50,000 in Isas.
| Income taken as % of portfolio | Real investment return | Income at 65 | Savings at 65 | Income at 75 | Savings at 75 | Income at 85 | Savings at 85 | Income at 95 | Savings at 95 |
| 4% | 0% | £11,881 | £150,000 | £10,036 | £99,725 | £8,533 | £66,300 | £7,644 | £44,709 |
| 4% | 2% | £11,881 | £150,000 | £10,783 | £122,561 | £9,887 | £100,011 | £9,154 | £81,823 |
| 4% | 4% | £11,881 | £150,000 | £11,881 | £150,000 | £11,881 | £150,000 | £11,881 | £150,000 |
| 8% | 4% | £17,881 | £150,000 | £13,859 | £99,725 | £11,185 | £66,300 | £10,206 | £44,709 |
| Assumes income taken from Sipp and Isa and includes tax deductions. | |||||||||
