Reconsider ditching your final-salary pension

"We are considering buying a second home or moving to a more expensive area on the south coast," says Jeremy. "We had thought of using £400,000 to buy a new home worth around £800,000. However my final-salary pension has a transfer value of £765,000, so if I transfer out of it we might take the 25 per cent tax-free entitlement and use £600,000 of our assets to buy a property worth up to £1m. If I don’t transfer out, at the end of this year the final-salary pension will start to pay out £26,500 a year and is index-linked.

“We have not yet drawn any funds from our self-invested personal pensions (Sipps), but plan to take the 25 per cent tax-free entitlement from my £355,000 Sipp. 

"We estimate that our outgoings are £40,000 a year, but would like the option of being able to spend more, for example on cars, holidays and spoiling our grandchildren. We want any drawdowns we make to be as tax-efficient as possible. We also don’t know whether we will have care costs in later life. But inheritance planning is not a concern as we intend to spend what we have.                 

"We are both entitled to the full state pension and my wife has a Sipp worth £25,000. £330,000 of our individual savings account (Isa) investments are in her name and £300,000 are in my name.

"We would like to reposition our investment portfolio for retirement. We have invested every year since 1994, and have a medium risk appetite so, on average, 65 per cent of our investments were in equities. But over the past six months we have become increasingly spooked by the political backdrop and retirement planning has weighed heavily on our minds. When Boris Johnson became prime minister and we realised that a general election was inevitable we de-risked our portfolios. We sold most of our UK, Europe and US equity exposure, and are holding the proceeds, which are worth £355,000, in cash within our Isas and Sipps. This has reduced our equity exposure within these wrappers to around 20 per cent, and we have 45 per cent in bonds, absolute return, gold and property funds, and 35 per cent in cash.

Jeremy and his wife's portfolio

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

THE BIG PICTURE

Chris Dillow, Investors Chronicle's economist, says:

The price you’ve been offered to transfer out of your final-salary pension is not as generous as it seems. To buy a retail price index (RPI) inflation-linked pension that starts at £26,500 per year would cost £960,000 at time of writing. So an offer of £765,000 is poor value. And why would anyone make you an offer if it wasn't a mean one? 

Even if you can get a more realistic valuation, it’s debatable whether you should take it. Staying in your your final-salary pension removes investment risk and longevity risk – the danger that you’ll live a long time, putting pressure on your finances. And an index-linked income protects you from inflation which is important because spikes in inflation often come at the same time as falls in bond and equity prices.

Your asset allocation also suggests that you are averse to risk - another important consideration. And economists have long spoken of an annuity puzzle – fewer people annuitise their wealth than theory suggests should. So think carefully before transferring out of your final-salary pension.

But transferring out of it might make sense if you aren’t going to live a long time, want to leave a decent bequest to your children or will incur expensive care costs in later life.

Also think carefully about your house move. Do you want a £1m house because it is a nice thing? Or is it that the moment £765,000 is mentioned, a £400,000 house seems inadequate even though it might have been quite satisfactory beforehand? That £765,000 transfer value might be distorting your perceptions.

Patrick Connolly, chartered financial planner at Chase de Vere, says:

You need to consider how you can generate a sustainable income in retirement. You estimate that you will need a net income of £40,000 a year and the option of spending more.

Your income in retirement will be made up of reliable secure income, and insecure income which might not be sustainable if your underlying investments fall in value. Everybody should aim to have a secure income in retirement that, at least, covers basic living costs. This is likely to come from state pensions, final-salary pensions and lifetime annuities. 

Your final-salary pension will start paying out £26,500 a year and is index-linked, so could be a useful part of a secure income that covers your basic living costs.

You are entitled to the full state pension from age 66 in 2021 and your wife from 2023. Your final-salary pension income and state pensions should provide a gross income of around £44,500 a year, which should mostly meet your basic living costs.

But you will need to make withdrawals from your investments to cover income shortfalls in the years before you start receiving your state pensions. You could make tax-free withdrawals from your Isas or encash your NS&I Premium Bonds.

If your wife is a non-taxpayer you could withdraw money from her pension over her 25 per cent tax-free entitlement as this will also be tax-free if she doesn’t exceed her income tax personal allowance.   

If you are a basic-rate income taxpayer and your wife is a non-taxpayer you could transfer £1,250 of your wife's personal allowance to you, meaning that you pay £250 less income tax in this tax year. Marriage tax allowances can also be backdated for the previous four tax years.

When you have a secure income in place to cover your basic living costs you could take a bit more risk with your other investments, knowing that whatever happens you’ll be able to pay your bills. This is better than gambling with money that you might need for day-to-day expenses.

Many people are tempted to give up the guaranteed and index-linked income a final-salary pension pays out for a large lump sum payment. But you must not underestimate the value of the final-salary pension as it will provide you with a secure, index-linked income for the rest of your lives and cover a good deal of your daily living costs. It will also give you peace of mind.

Although a lump sum of £765,000 sounds attractive, taking the money and investing it in a self-managed pension is a riskier approach and will not seem like such a good idea if the investment value falls – especially if you are making withdrawals at the same time. The fact that you are spooked by markets suggests that taking more risk might not be a good idea.

You also have plenty of accessible money in other assets for additional or unexpected expenses. 

There would be a stronger argument in favour of giving up your final-salary pension if you were in poor health or wanted to pass on assets to your children.

If you plan to take money from your pensions or Isas and invest in property you would move money away from a tax-efficient environment. You don’t seem to particularly need a bigger house so it’s difficult to see the benefit of tying up more money in property.

If you're planning to buy a second home you will move tax-efficient investments into something that is likely to be heavily taxed. It is also potentially risky due to possible capital losses, ongoing costs and high taxes, and the potential aggravation of having tenants. If you don’t have a good reason to access money held in a tax-efficient pension wrapper, leave it there.

Kay Ingram, chartered financial planner at LEBC Group, says: 

 According to the analysis of your spending, you need £32,000 for day-to-day living costs and about £8,000 for leisure activities. So your priority is to secure this income and ensure that it keeps pace with expected inflation throughout both of your lives. Only when you have achieved this should you consider buying a second home or additional discretionary spending.

Following changes to the state pension in 2016, most people have a mixture of the old and new schemes, which can mean receiving more or less than the new single-tier pension of £169.20 a week. This depends on your individual National Insurance record and whether you have been in a pension scheme contracted out of the old state earnings-related top-up scheme. Getting an individual statement from the Department for Work and Pensions is the only way to be certain – you can check this at www.gov.uk/check-state-pension.

You have guaranteed and inflation-protected income from your final-salary pension starting at £26,500 a year. The new single-tier state pension will be £175.20 per week, or £9,110 a year, from April 2020. It increases each year by the higher of consumer price index inflation, national average earnings or 2.5 per cent, and you will both qualify for it from age 66. 

You have an income shortfall of £16,300, which will fall to £9,012 when your state pension starts paying out. When your wife's state pension starts paying out in 2023 that will close the gap. You could meet the shortfall by cashing in your NS&I Premium Bonds each year until 2023. NS&I Premium Bonds pay no income and any return, which on average is 1.25 per cent, depends on luck.

To achieve tax efficiency, your wife should elect to share the marriage allowance with you. She is a non-taxpayer with income well below the tax-free allowance of £12,500 and could transfer 10 per cent of this – £1,250 – to you. This would increase the amount of tax-free income you could receive and potentially save you £250 a year in tax. If your wife has been a non-taxpayer for any of the past four tax years and you had taxable income of less than £50,000 a year, the allowance can be backdated, giving you a tax refund of up to £1,137. Neither of you are likely to be more than 20 per cent rate income tax payers in the long term as you have saved in Isas. 

You are tempted to give up your final-salary pension for a lump sum of £765,000, which you would invest in a drawdown plan. But your final-salary pension would provide the bulk of the income you need for day-to-day costs with guaranteed inflation protection. £765,000 would only buy a guaranteed income of £18,742 a year from the top annuity provider. If you retain the final-salary pension it will give you greater certainty of a lifetime income, and you can use your other investments to fund leisure activities and a new home.

You would also have the added responsibility and cost of managing the drawdown portfolio for the rest of your lives. You are experienced investors and have done well to grow your investments to their current value, but given your worries about political risk you do not appear to have the appetite to take on more risk. If markets take a downturn but you have retained your final-salary pension, you will only have to worry about how to finance discretionary spending. If you accept the transfer value then the bulk of your income will also depend on investment returns and this probably represents too much risk for you. This would particularly be the case if you used some of the pension funds to buy a larger property, leaving you with a smaller fund to provide income. Our cash flow analysis shows that in this scenario you would face a serious risk of running out of liquid funds in your late 80s or early 90s.

If you transfer your final-salary pension into a drawdown plan you also need to consider who you would appoint as your attorney to manage the withdrawal of funds if you were no longer able to do this. An alternative would be to use what was left in this pot to buy an annuity later in life, as your age and health situation might mean you qualify for a higher level of guaranteed income. 

Before you transfer out of a final-salary pension you have to speak to an adviser authorised by the Financial Conduct Authority (FCA) on this, who will charge a fee for the advice. The FCA requires the adviser to start from the position that a transfer out is unlikely to be in your interests, and to only recommend transferring if there are exceptional reasons as to why you might benefit from it.

If you die first your state pension and occupational pension will reduce, so your wife needs to understand what ongoing income she might receive from the occupational scheme. This is determined by the scheme rules and she is only likely to get a share of any earnings-related state pension you have built up. Enough funds from the Isas and Sipps should be retained to enable her to replace some of this.

You should both nominate the other to receive your Sipps when you die so that the survivor can continue to draw funds from them. You should also ensure that your wills leave assets to each other so that the surviving spouse can keep all the Isas which pay income and grow tax-free. This allowance must be claimed within three years of death. The survivor can then change the nominees and beneficiaries to your children, who can inherit the pension plans without incurring inheritance tax.

How much you spend on a second home will be determined by how much of your Sipps and Isas you want to retain for discretionary income. A second home will also incur additional costs and a stamp duty surcharge of 3 per cent. If you then sell a property that is not your main residence you will incur capital gains tax. Although our cash flow plan suggests that you could afford to do this by, for example, cashing in your Isas, the additional spending on running the property would leave less in your Sipps to provide for longer-term income or short-term discretionary spending. So it may be more viable to have only one home, freeing up more of your savings to produce additional income for spending on leisure breaks and lifetime gifts to the family.

HOW TO IMPROVE THE PORTFOLIO

Chris Dillow says:

Your Isas and Sipps are well positioned for a stock market fall caused by fears of recession and a fall in sterling due to factors such as a no-deal Brexit. But insurance always comes at a price, and when it is in the form of bonds the price is a loss in the value of these assets if we avoid recession and economic growth continues. Negative real bond yields are, in effect, a tax on wealth.

Gold also isn’t much help as its price would probably fall if bond prices go down. This is because when you hold gold you give up the income you could get on bonds. When bond yields are low gold is attractive and its price is high. But as yields rise, gold becomes more expensive to hold so its price falls.

This means at some point you may have to increase your equity exposure. As the dividend yield is above average and, in the past, this has been a good predictor of longer-term returns – this time might be soon.

I’ve long been wary of absolute return funds. I’m not sure that these do anything for you that you can’t achieve yourself with a mix of equities, bonds, cash and gold. So you might want to consider reducing your holdings in these in favour of equities at some point.

Patrick Connolly says:

Having your assets in tax-efficient pensions and Isas will help you to achieve a tax-efficient income and capital growth in retirement.

You have recently reduced the equity weighting of your investments from 65 per cent to 20 per cent and increased the cash to 35 per cent, so are very defensively positioned. But making short-term tactical calls is a difficult game to play. For example, you could be too heavily invested in shares as stock markets fall, or have too much money in cash and fixed interest when stock markets are rising. And cash holdings are likely to produce a negative return when inflation is taken into account.

It is understandable that you have been spooked with so much uncertainty in the UK, but there is always uncertainty in investment markets. Who knows, for example, how the 2020 US presidential election will work out or if there will be an increase in tensions in the Middle East? Next year is likely to bring other concerns that investors haven’t even thought of.

Rather than trying to predict short-term market movements, it’s better to adopt a long-term strategy that suits your objectives and attitude to risk, and stick with it, ignoring any background noise or short-term market sentiment. If you have a secure income that covers your basic living costs you can afford to take some investment risk.

You may want long-term capital growth and income. You need to hold enough money in equities to benefit from their growth potential, alongside more secure assets such as cash and fixed interest to provide diversification and protection if markets fall.

The right approach for you depends on your individual circumstances and attitude to risk, although a diversified portfolio with 50 per cent in equities, 35 per cent in fixed interest and absolute return funds, and 15 per cent in cash including NS&I Premium Bonds, could be a reasonable blend.

Passive investments can provide broad exposure to different markets at a very low cost and, as many active funds fail to beat indices, a combination of active and passive funds can be a good approach. So look to increase your weighting to passive funds.

You are significantly underweight the UK. This is understandable considering the uncertainty, and many overseas investors have also been avoiding UK equities. But most UK investors should have a significant weighting to their home country as this can help to reduce currency risk. If there is a perceived good outcome to Brexit this will be beneficial to domestically orientated UK companies. But this would be likely to strengthen sterling and be detrimental to UK-listed companies with overseas assets and/or that make most of their earnings overseas.

If there is a perceived negative Brexit outcome sterling is likely to weaken. This would benefit UK-listed companies with overseas assets and/or that make most of their earnings overseas because these will be worth more when converted into sterling.

So by investing in domestic-exposed UK companies and overseas earners you may be able to hedge your bets. You could increase your weighting to your existing UK funds, Fidelity Index UK (GB00BJS8SF95), Liontrust Special Situations (GB00B57H4F11) and Threadneedle UK Equity Income (GB00B8169Q14). An alternative fund could be Man GLG Undervalued Assets (GB00BFH3NC99).

In the current environment we favour flexible strategic bond funds run by experienced managers such as Jupiter Strategic Bond (GB00BN8T5935) or Baillie Gifford Strategic Bond (GB0005947857).

Once again, there are liquidity concerns over property funds. But property is a long-term investment rather than an asset for trading tactically, so a small weighting to it is fine and Janus Henderson is an experienced property manager.

We don’t typically include gold in our clients' portfolios, but it can be a good diversifier to have a small weighting to – as you do.