Pension freedom: what to consider before choosing a pension portfolio
Pension freedom is an amazing thing – as long as you make sensible decisions. The original worries of everyone going out and buying a Ferrari haven’t come to fruition thankfully, and most people haven’t been silly with their hard-earned savings.
Pensions have become a lot more attractive thanks to the 2015 legislation that gave us control over our money in later life and the ability to draw down when we choose as we reach retirement. It also gives us peace of mind knowing that under these rules, on our death our family still gets the money in our pension fund (rather than payments ending as they did under the enforced annuities system).
As for the previously mandated annuities, they still have a role to play. Here are my answers to common questions I hear about pensions in the age of freedom.
Why would I still buy an annuity in the era of pension freedom?
It provides you with certainty. As we go through life, we want more and more certainty. As a teenager we want variety and excitement, but as we get older we generally want to take less risk.
For most people, covering basic living expenses via some form of annuity and state pension gives them absolute security, regardless of what’s happening on the stock market. If they invest the money instead, while a sensible strategy should look after that investment, there is risk involved. In 2007/8 if the markets had continued to fall, pensions would have been eroded further. That doesn’t happen with an annuity.
Who should take out an annuity?
Someone with a very low tolerance for risk; and people with a ‘small’ pension fund (which is a subjective term of course) should also strongly consider it.
That’s because the income you take is (usually) a fixed amount, not a percentage of your overall pension pot. Let’s suppose you wanted a guaranteed £1,000 per month – if that’s coming out of a £200,000 pension pot, that’s 6% annually. But when markets crash they typically fall up to 50%, so suddenly you’re taking from a £100,000 pot, or 12% annually. Around 3-4% annually is the level of drawdown you can safely take from your retirement pot without it running out as you get older, so this would not be a good situation.
People with a smaller investment pot should consider annuitising because the income they take is a fixed amount from a variable pension pot which goes up and down.
But the pension’s invested throughout my life, why should I be more cautious about my pension freedom choice now I’m older?
Because during your working life you still have the capacity to earn money. As we reach retirement age our ability to earn more money gradually reduces, and once retired we have, in theory, much less capacity to earn money. That means we need more security as we get older, so an annuity can make very good sense.
What are the dangers in pension freedom legislation?
People aren’t always aware of what they should be doing with that money. An individual typically isn’t qualified to understand what to do with a drawdown, they have no experience in managing that level of money in one go.
To use an analogy, if you never learned to drive you wouldn’t suddenly get in a car and go shopping. Therefore, it’s absolutely critical to take appropriate advice. You need to go to a regulated adviser – a certified financial planner – you can find a list on the FCA website (hyperlink).
How important is that regulation? It’s an absolute must. For example, when you see the self-storage schemes in the media that have blown up after offering too-good-to-be-true returns on investment, they’re not regulated. Just because they’re offering something to you doesn’t mean you should accept it. If you’re sick, you go and see a registered doctor, not a witchdoctor. Your pension is no different. Advisers have been educated, tested and regulated, and that matters.
So the first thing to do when I want to draw down is go see an FCA-regulated adviser?
You should seek advice when you start saving for your retirement, not when you get there. Put a plan in place with an adviser and then do periodic check-ins – I’d recommend every 5 years – to check you’re still on track to achieve it.
If we go to a dentist at 18, they’ll tell us to clean our teeth every day and not consume too much sugar. If we don’t go back for another 40 years, it’s not the dentist’s fault if our teeth are falling out!
It’s the same with your financial plan – companies change, charges change, lots of things can change, so make sure you’re checking in once in a while. As you get older you may want to check in more often, perhaps annually as you approach retirement, just to make sure your outcomes look like they’re on track with your goals.
What’s the rule of thumb for how much risk I should be taking with my portfolio?
My rule is: 100 minus your age is the percentage of your savings you should have in the stock market. In your 20s you can tolerate up to 80%, because again you have earning time on your side. As you reach 50, consider taking it down to a 50/50 split, and so on.
The only caveat I give to that is that the market can correct about 50%. Whatever your age, if you can’t accept that level of correction, then dial it down.
So if you’re 50 years old and have £100,000 saved, with half in the stock market, a crash could take your total down by £25,000. You wouldn’t be happy about that of course, but if you’re comfortable that it might happen and you’re taking a long-term view, that’s fine. If that scenario makes you freak out, then you need to lower your risk exposure by reducing your market exposure in your portfolio, increasing your fixed income portion instead (which is less volatile).
Should I continue paying into my workplace pension or look to invest privately myself instead?
Step 1 is always your workplace pension, because your employer pays into it too so you’re doubling your money – you get 100% return on your money immediately. For most people it’s a simple, inexpensive and extremely effective way to save.