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Should annuities form a part of our retirement income?

These investors want to secure a good retirement income amid market uncertainty
November 4, 2022 and Scott Gallacher

Rising interest rates mean annuities could be a good way to receive retirement income

They could use some rather than all of their pensions pots to buy an annuity

Being married or in a civil partnership could reduce these investors IHT liability

 

Reader Portfolio
Chris and his partner 62 and 60
Description

Pensions and Isas invested in shares and funds, cash, residential property.

Objectives

Retire in near future; use sale proceeds of buy-to-let property to fund holidays, Isa contributions and help children buy homes; leave assets to children; mitigate IHT; supplement income in retirement; determine best way to take pension benefits.  

Portfolio type
Investing for goals

Chris is age 62 and his partner is 60. He earns £55,000 a year and she has retired but not yet drawn from her defined-contribution (DC) pension, which is worth about £160,000 and managed by her financial adviser.

They have five children between them.

Chris and his partner live in her home which is worth about £750,000 and is mortgage free. Chris also owns a buy-to-let property worth about £360,000 which is mortgage free and produces income of £965 a month. 

"I delayed taking retirement initially because of working from home during Covid-19," says Chris. "And now with the war in Ukraine and climbing inflation I have recently sold a buy-to-let property for £335,000 to free up cash so that I can retire, though have capital gains tax to pay as I bought it for £290,000 five years ago. I don't intend to sell my other buy-to-let property for a number of years.

"I will use the proceeds of this sale to fund holidays and contributions to my individual savings account (Isa) in the first few years of retirement. We also wish to make some home improvements. With retirement imminent, and our state pensions starting to pay out in five years, I think that using the cash from the house sale is more efficient from an inheritance tax (IHT) perspective. We will also use this money to help our children buy homes meaning that we can leave our pensions untouched until we need them.

"When the sale proceeds of this property run out, we will draw from the 25 per cent tax free elements of our pensions to help cover our living expenses, together with our state pensions and my buy-to-let income. I expect to receive the full state pension but my partner has not made enough National Insurance contributions to receive it in full.

"Depending on our tax positions, we might also supplement our income by taking the income from our investments – if they are worth keeping in the current investment environment. With so much uncertainty in markets, we are considering using all of the assets in our DC pensions to buy annuities, to try to ease our worries and take advantage of current higher rates. It would be nice not worry about every bit of bad news impacting the markets and my pension. That said, this negative news is probably short term and performance over the next 20 years is more important.

"I have three personal pensions worth about £262,000, £394,000 and £10,000, and a defined benefit (DB) pension which should pay out £400 a month when I retire.

"My partner and I plan to become civil partners and combine our assets under a joint will. This is to ensure that she will benefit from my pensions and rental income if I die before her, and, after having invested a considerable sum in our home, can continue to live in it if she dies before me. After both our deaths, our assets will be left equally to our five children. 

"I had a Portfolio Clinic review in October 2020 (Focus on total return to reduce risk, IC, 2 Oct 2022 ) after which I started to think about what income I need after tax and our future needs rather than aiming for a certain a rate of return from my investments. As a result, I positioned myself to receive bond and equity income from my £394,000 pension which last year amounted to £15,000.

"But as I do not need income from my investments in the near future because I have the proceeds from the sale of my property, should I maybe reduce my exposure to bond investments? I am investing with a 25-year investment time horizon in mind, so with income from bonds not the biggest priority should I keep them or have a growth portfolio with, say, an 80 per cent/20 per cent equity/bond allocation?"

 

Chris and his partner's total portfolio
HoldingValue (£)% of the portfolio
Cash570,63832.29
Buy-to-let property360,00020.37
Partner's pension160,0009.05
Aviva Pension My Future Consolidation (GB00B84QS166)129,8217.35
Baillie Gifford Japan Trust (BGFD)44,4612.52
Legal & General (LGEN)41,3702.34
Tritax Big Box REIT (BBOX)35,0661.98
M&G (MNG)33,4901.9
LF Blue Whale Growth (GB00BD6PG670) 31,5201.78
Baillie Gifford American (GB0006061856)28,9251.64
Aviva Pension North American (GB00B00H4R58)28,7411.63
JPMorgan European Growth & Income (JEGI)27,9741.58
Royal London Sterling Extra Yield Bond (IE00BJBQC361)26,0041.47
FTF ClearBridge Global Infrastructure Income (GB00BMF7D779)24,8221.4
Aviva Investors UK Listed Equity Income (GB0004460803)24,0341.36
Invesco Bond Income Plus (BIPS)22,0641.25
Chris investment Isa21,0001.19
Fidelity China Special Situations (FCSS)19,7001.11
Fundsmith Equity (GB00B4MR8G82)19,7001.11
Royal London Global Bond Opportunities (IE00BYTYX230)18,9121.07
Liontrust Sustainable Future Monthly Income Bond (GB00B44MQ015)17,7301
Jupiter Strategic Bond (GB00BN8T5596)17,3360.98
Baillie Gifford International (GB0005940316)14,4360.82
HL Select Global Growth Shares (GB00BJFVF498)11,8200.67
Legal & General International Index (GB00BG0QP596)11,8200.67
Chris pension10,0000.57
Aviva Pension European (GB00B00GWM38)8,2530.47
Aviva Pension Global Equity (GB00B00H7G58)7,3620.42
Total1767000 

 

NONE OF THE COMMENTARY BELOW SHOULD BE REGARDED AS ADVICE. IT IS GENERAL INFORMATION BASED ON A SNAPSHOT OF THESE INVESTORS' CIRCUMSTANCES.

 

Scott Gallacher, chartered financial planner at Rowley Turton, says:

Your own and your partner's financial position indicates that you could easily spend £60,000 a year or £5,000 a month without any real fear of running out of money. However, there are some financial planning issues.

The biggest of these is IHT. Depending on how your wills are worded, your IHT liability could be around £470,000. This is partly because you are unmarried so will not inherit each other's IHT nil-rate bands.

Delaying drawing from your pensions and using the cash from the house sale is more efficient from an IHT perspective. However, it’s not necessarily this straightforward as by doing this you won’t make full use of both your personal allowances. So consider drawing some pension income to make use of these allowances.

It might be a good idea to draw your DB pension now, subject to the deferment rate you are receiving. And your partner should make voluntary National Insurance contributions to boost her state pension. When you come to draw your pensions, do consider annuities. Although these have been overlooked for many years due to relatively low rates, rising interest rates have put them back on the table as a good option.

Marriage or a civil partnership could reduce your IHT liability by up to £200,000. If you wish to protect your existing assets in case things don’t work out, you could put in place a pre-nuptial agreement.

If you were married, you could have used both of your capital gains tax allowances and reduced the amount payable on the recent sale of the rental property. Although it is now too late for this property, this planning opportunity could be a option if you sell your remaining rental property.

As you plan to help your children buy homes, it might be better to make those gifts sooner rather than later to increase the chance that you will live for seven years after making them meaning that they are IHT-free. And consider taking out with seven year life assurance policies to cover any IHT if you die within seven years of making the gifts. This way you reduce the likelihood of any IHT being payable as well as reducing the cost of any life assurance cover.

You are right to think about what income you need after tax rather than aiming for a certain a rate of return from your investments. But the investments are very punchy. You also have too much cash. With today’s high inflation, it might be better to invest some of it in a well diversified portfolio to offset that inflation risk.

 

Hermione Taylor, economics writer at Investors' Chronicle, says:

It is not surprising that you are worried about the news – it has been a nerve-racking time for investors and economics reporters alike. 

The global backdrop is challenging: Deutsche Bank research recently showed that 2022 has been one of the toughest years for financial markets in decades. Bonds and equities have declined in unison, and government bonds have entered their first global bear market in 70 years. There are also UK-specific challenges to contend with – not least the new government’s battle to restore economic credibility and the recession that we are now forecast to wallow in for the next 18 months. 

The Bank of England recently cautioned that further increases in the Bank Rate may be required to get inflation back down to target, and economists now expect rates to peak somewhere between 4 and 5 per cent next year. Even the lower estimate would represent the highest rates in almost 15 years. Higher rates will have several negative consequences but should be good news for annuities. 

Annuity rates are closely linked to 15-year gilt yields and, although bond yields and interest rates don't move in lockstep, rising interest rates should mean an end to the rock bottom benchmark annuity rates seen over the past five years. 

But inflation remains an important consideration. It is still expected to peak sometime later this year, though there is now more uncertainty about how long its walk back down to target will take. Inflation-linked annuities are available, but these are expensive and no one – including the Bank of England – is sure how long high inflation will persist. 

With rates rising, you may have chosen a good moment to reduce your exposure to the housing market. If interest rates increase as anticipated, the impact on mortgage affordability will be substantial. Economists are now predicting a house price drop of 10-15 per cent in 2023. The fact that your remaining rental property is mortgage free should also provide you with some peace of mind. 

With bonds and equities both declining this year, the question of portfolio balance is a good one. The adjustment to a higher inflation, higher-yield environment has impacted both stocks and bonds, and correlations between the two have shifted drastically. Whereas bonds provided positive returns (or at least minimised portfolio losses) when stocks fell in 2008, they have provided limited protection this year.

There is little consensus on how long this will last: historical evidence suggests that correlations between stocks and bonds go through long cycles, but there is also an argument that the relationship will be short-lived, normalising as inflation falls and interest rates drop again. No one can pretend to know where markets are heading at the best of times –  and this certainly doesn’t feel like the best of times.

Nevertheless, now could be a good timeto think about your attitude to risk. Movingto an 80:20 portfolio would mean a riskier rebalancing, yet you are also considering moving out of markets to spare the agonies of following news. In this case, annuity income could be a valuable source of security. But you need not make a binary decision on whether to use all of the assets in your DC pensions – consider whether an element of annuity income might make sense.

It is also worth considering whether you want to trade off the potential of higher returns in favour of a very low-risk approach. I notice that you have a good deal of variable spending ahead of you in the form of holidays, renovations and family events.

And in case you need any encouragement from the sphere of economics, research has shown that ‘memorable goods’ such as holidays continue to provide us with utility for years to come.