The UK’s pension reforms took effect Monday, giving new retirees unprecedented freedom. Out with the perceived de facto requirement for most to buy an annuity, in with choice! And with it, a potentially overwhelming flurry of new products, aggressive cold-callers, flashy marketing and, unfortunately, shady characters seeking to prey on newly free pensioners. Her Majesty’s trusty aides are trying to help via the snazzy new “Pension Wise,” but early reviews of the online service aren’t smashing. What’s the discerning pensioner to do? Here are a few tips.
As a refresher, new retirees now have five primary options:
Withdraw 25% tax-free and the rest at marginal income tax rates to spend or invest as per your wishes
Withdraw 25% tax-free, if desired, and leave the rest invested within the pension wrapper, enrolled in “Flexi- Access drawdown” plans
Leave your savings invested within the pension wrapper without buying an annuity or entering a drawdown arrangement, and take ad hoc “uncrystallised fund pension lump sum” distributions as you wish—with 25% of each distribution tax-free, 75% at marginal income tax rates
Withdraw 25% tax-free, if desired, and/or buy an annuity
Freedom of choice also comes with freedom to fail. Identifying your goals, accurately assessing your time horizon and figuring out which mix of assets best helps you reach them is crucial to reducing your error rate. For ages, insurance firms did all the work, calculating your life expectancy and leaving it to you to select from various annuity types and rates. Now, that’s changing, and if you wish to capitalize on your freedoms, it’s up to you to calculate your time horizon—how long your assets must be invested to reach your goals.
Many folks need their money to last at least their lifespan (perhaps longer, if providing for family), making it paramount that you don’t underestimate your life expectancy—something many are prone to doing. Statistics show folks are living longer and longer, and you’ll want to make sure you have money to see you through. If you’re in good health and retiring today, you could have a time horizon of 30 years or more.
With the expansion of flexible drawdown to all pensioners comes competition for all those assets. New funds are popping up left and right. A “buy-to-let” fund, pooling money to invest indirectly in rental properties, launched last Autumn—letting landlords swap properties they own directly for fund shares within their pension (eeek). A wave of target-date funds (TDFs), increasingly popular stateside, has sprung up this year. TDFs are jazzy versions of Britain’s popular lifestyle funds. Like lifestyle funds, their asset allocation changes as you age, with the stock weighting dialed down and the bond component cranked up. But unlike lifestyle funds, many are actively managed, gunning for higher short-term returns and aiming to navigate market cycles. And even though they’re advertised as “set it and forget it,” that applies to the fundholder only—in America, several TDFs have ratcheted up stock exposure during this bull market, basically chasing heat. Also like lifestyle funds, TDFs trade on the myth that age alone should determine your investments, with no regard to your unique long-term goals, cash flow needs and time horizon. Fact is, there is no one automatically correct blend of stocks and bonds for any age. For example: Jim, 67, doesn’t need to live off his pension pot, and aims to grow it and leave a legacy. Nigel, also 67, has £400,000 in his plan and needs £25,000 annually between his state and employer pensions. He has no heirs. Should their age really make all the difference in allocation? Not in our view—goals matter.
Deferred annuities will also be rolling out soon—a lot like the US has now. Like Britain’s traditional immediate annuities, they offer “guaranteed” income, but they allow you to invest and grow your savings before annuitizing. So if you’re retiring today but don’t need cash flow for another 10 years or so, they might look wonderful. But US investors have learned these aren’t so great. Typically, some combination of high fees, limited investment options, performance caps and complex terms eat into long-term returns, reducing the advertised benefits. In America, those “guarantees” are purchased as add-ons called benefit riders carrying high fees and strict limitations, and they often aren’t as ironclad as you might think. Just a cautionary tale of something that may arrive on British shores in the not-so-distant future.
The drawdown landscape is also changing, and not all providers are accommodating the full range of new freedoms. Many won’t offer the full Flexi-Access regime and most will only offer the one time uncrystallised fund pension lump sum option if the whole pension is paid as a lump sum, 25% tax free, 75% taxed at marginal income tax rates. Some will charge fees on ad hoc withdrawals, others will mandate you seek advice when transferring internally to a suitable “drawdown contract,” advice that may not be free. Some firms will charge flat fees, ranging from a few hundred to a thousand pounds or more for various services and transactions. Others will have percentage-based charges, and it’s up to you to do the math and find the best value for the service you get. Different outlets will offer different investment options. Know your plan! And know your withdrawal options. Retirees in “capped drawdown” plans, a legacy of the former system, can currently take withdrawals up to 150% of the amount an equivalent annuity would kick off. Those limits still apply to these plans, and if you exceed them, you will be flipped into “Flexi-Access drawdown,” the new normal. Thing is, your ability to continue investing up to £40,000 in your pension annually and obtain tax relief falls to £10,000 in Flexi-Access drawdown. And the tax man, as always, will cometh. Outside of the 25% tax-free slice, distributions will be taxed at marginal income tax rates, and higher distributions can bump you into higher income thresholds. Don’t leap blindly—do the math and talk to your adviser.
Some folks might say, “forget all that complexity—I’ll cash in and become a buy-to-let landlord.” We guess that’s one way to avoid hassle, though being a landlord comes with its own headaches, like property management. Plus, there are a bunch of potential drawbacks to this ideal of living off rental income. Though the tax penalty for cashing in your full pension is no longer 55%, normal income tax rates still bite hard. Your property purchase options might be more limited than you think after the Treasury takes its cut, which carries a big opportunity cost. There is no guarantee you’ll find tenants. What’s more, real estate is illiquid—if you have an unforeseen need for your money, things could get dicey. Property values can get volatile (see 2006 – 2010)—and diversifying is tough, considering true diversity would require you buy in multiple regions—a huge initial investment may be required. And unlike most pensions, real estate is potentially subject to capital gains and inheritance taxes. All this, and, over time, real estate doesn’t match stocks’ return.
Already retired and locked into annuity? You may not be left out for long. The 2015 Budget contained plans to introduce a secondary market for annuities, allowing you to sell your lifetime income rights for up-front cash. That comes with a whole separate list of pros, cons and risks to understand—we’ll share more (and some anecdotes from America’s secondary annuity market) when and if details emerge.
In the meantime, three cheers for flexibility and freedom to choose! But do your due-dilligence, be discerning, and don’t get blinded by flashy tactics and unrealistic promises.