Pension choices: Will you make the right decision?


AS of April 2015, anyone approaching pensionable age has had far more choice - and far more responsibility - regarding their future finances.

People are no longer obliged to buy annuities with their pension funds, and for many there's a great temptation to get their hands on the money they've had locked away for years.

But the average person burns through their savings in just seven years - while most of us will live for at least a decade after we retire. Now, more than ever, it's vital to consider how to make the money last.

So what are the options, and which is right for you?

The options, at their simplest

The International Longevity Centre-UK (ILC-UK) have carried out research into how people respond to similar levels of pension freedom in other countries. From that, they've created four simple models based on the most common outcomes:

The ILC admits these are very broad scenarios and don't take into account that people may opt for a combination, or change their minds - but they provide a good jumping off point for anyone considering what to do.

Buying an annuity

Had the obligation to buy an annuity not been removed, ILC-UK's figures still make stark reading.

They say that across England there are roughly two million people aged 55 and above who have yet to retire, and who have at least one defined contributions (DC) pension. Only half of them have more than £37,000 saved in those pensions.

If those two million people use everything in their pension pots to buy annuities, more than half won't have an adequate annual income unless they also rely on both the State Pension and other benefits, or have other non-pension assets to fall back on.

All the same, people who buy annuities with their DC pensions can currently expect to have about 70% of their pre-retirement income.

Pros Cons
Guaranteed income for life, no matter how long that is
Can be tailored to increase over time - either by set amounts or to take account of inflation
Any money remaining after death now tax-free for beneficiaries
No room for flexibility in the face of financial shock
Lack of transparency around how calculations and fees work
Locked in to a rate of return at the point of purchase
Perception of poor return: "What if I die earlier than expected?"

In a survey of people who already had annuities, carried out by Saga, a quarter of people said they'd like the option to sell theirs, and 20% thought they probably would if given the chance.

Of those who were thinking about it, 58% said their monthly income was too small to use meaningfully.

Blowing the lot

But the Saga survey also showed that just 12% of people said they wanted to spend the money on luxuries such as cars or holidays.

Another 10% said they'd spend their savings on their loved ones - and 8% said they'd use it to cover day to day spending and pay off their debts.

This backs up research carried out by Citizens Advice, who say people's pension decisions are very rarely made in isolation.

For example, those who've been working hard just to keep up with bills or debts as they approach retirement will be more focused on covering those costs than planning longer term.

ILC-UK's research suggests that people who do choose to withdraw all the money can expect their retirement income to drop to just 40% of its pre-retirement level.

Pros Cons
Being able to clear overhanging debts before full retirement
Sense of reward after long working life
Some ways of "blowing it", like helping children buy a home, may have returns later
Once the money is gone, it's gone
Pressure to use pension savings to help struggling family members
People most likely to blow the lot are those with less "financial capability"- more likely to need help later


Saga also found that a third of people would rather invest their pension funds in an ISA or the stock market instead of an annuity.

Savings accounts are familiar to us, and much easier to understand than annuities. But going down this route means taking on all the responsibility of looking after the money for ourselves, with few of the benefits.

And no one wants to think about how long they're going to live - which is a crucial part of the calculation when working out how much of our savings we can afford to use each year.

To add to that problem, ILC-UK say people are consistently pessimistic about their life spans, underestimating how long they'll live by at least four years.

They say, then, that for the years people have calculated - assuming no financial shocks further eating into the main sum - people who put their money into savings should expect an income of roughly two thirds the pre-retirement level.

But if there are unexpected bills, that money will run out sooner - and once it does, the amount people can expect to live on will be around half of their pre-retirement income.

Relying on savings also means people have little, if any, protection against inflation - and keeping money in the same account for years will gradually result in the interest rate dwindling to almost nothing.

Pros Cons
More control over how and where money is invested
Flexibility and accessibility in the face of any financial shocks
Allows for steady income over time if well planned
Shifts responsibility for long term financial planning to the retiree
People underestimate how long they need to make the money last
Too many financial shocks or lack of adequate planning will cause money to run out sooner
Savings generally offer next to nothing in terms of returns compared to inflation

Investing and drawing down

At the time of writing, ILC-UK say there is already evidence of the growing popularity of income drawdown as a method of funding retirement.

Before the pension reforms announced in 2014, there was a minimum income requirement of at least £12,000 a year from other sources before drawdown was allowed.

But that restriction was removed, so people with far smaller funds could choose to keep their money in their pension funds or other investments, then draw down an income of up to 150% of what they could expect to receive from an annuity.

Now consider that the stock market has consistently outperformed other forms of money management over the long term, and that most of us see our pension contributions invested in the stock market until we're ready to collect them.

If that's where's best to invest until we need the money in the future, why not continue to invest there for the years ahead?

Finally, drawdown doesn't have to mean finding somewhere new to invest our money - it's entirely possible to leave it in the pension funds we've been contributing to and organise drawdown from that.

Given those reasons, drawdown can appear to be a simple and rather attractive option.

But short term volatility can significantly affect how much people are able to draw down each year. In fact, ILC-UK calculated that with a "balanced" investment fund, average annual income could fluctuate between £18,000 and £12,000 a year.

annuity vs income drawdown

SOURCE: ILC-UK, Here today, gone tomorrow. How today's retirement choices could affect financial resilience over the long term. Available here [pdf]

Unless people have back-up funds that can help cover any yearly differences, they could find themselves falling into debt or having to significantly cut back.

And once more, people don't account for how long they're going to live. While they have funds, people can expect to have an income equivalent to around three quarters of their pre-retirement income.

But when the money runs out, people who rely on drawdown will find their incomes drop to just 49% of what it was when they were working.

Pros Cons
Possibility of higher returns
Higher comparative income than other options while the money lasts
Reasonable flexibility and accessibility
Market volatility can significantly affect yearly income
Responsibility for making the money last falls on the pensioner
Greatest difference in income before and after the money runs out

Other issues

As we said earlier, ILC-UK's models don't take into account that people may choose a combination of options, or change their minds as time goes on.

But there are other things to think about as well as how to use the money.


The most immediate stumbling block many people will face is that of taxation.

As we explained here, the old rules allowed people to take out 25% of their pension savings as a lump sum tax free, but a subtle shift in the wording could mean thousands of people are hit with far larger than expected tax bills.

Now they can withdraw as many lump sums as they want - but only the first 25% of each withdrawal will be tax free, and the rest will be taxed at their marginal rate.

So someone with a £100,000 fund could previously have withdrawn £25,000 tax free. Now, if they withdrew £25,000 they'd only get £5,000 tax free, and have to pay tax on the other £20,000.

Fantasy versus reality

Citizens Advice say they've found a marked difference between how people imagine retirement should be, and the reality of it.

Instead of taking long holidays and starting interesting new hobbies, their study [pdf] tells of people whose idea of feeling flush means being able to go to the bingo that week.

As we've covered before, one in five people in the UK has resigned themselves to never retiring, and ILC-UK have suggested that a large proportion of people approaching traditional retirement age would prefer to keep working, no matter the reason.

SOURCE: Citizens Advice, How people think about older age and pensions. Available here [pdf]

Lack of savings

Pensions are often the only form of savings many people have - and while auto-enrolment will introduce a further eight to nine million people to pensions, those contributions are unlikely to be enough.

In fact, research from the Pensions Policy Institute suggests that, based on minimum contribution rates through auto-enrolment, less than half of people with average incomes will have enough money coming in during retirement.

Both ILC-UK and the British Banking Association have called for savings to become much more commonplace in British culture again.

Building up a little extra wherever else we can might be the difference between living comfortably and having to significantly drop our standards of living - and help us deal with unforeseen circumstances without having to go into debt.

Lack of information

Finally, people simply don't feel they have enough information or understanding of the information available to make the right choices for them.

A TD Direct survey found that 46% of people aged 30 or above didn't think they had enough guidance to make the right choices, and 48% don't trust the pensions industry to do the right thing by them.

Considering the Financial Conduct Authority is putting considerable pressure on pension providers to check what their customers intend to do with their money to help prevent scams and really bad decisions, that may not sit well with many people.

In addition, Citizens Advice say many of their users are uneasy about independent financial advisors in part because of the cost, but also because they don't trust them.

Citizens Advice are running the face-to-face portion of the Government's Pension Wise service, which offers free and impartial advice to anyone wondering what to do with their pension fund.

The service is also available online and over the phone, and there's no limit to how many times someone can access it - which is just as well, as what's best for someone now may not be as good for them if their circumstances change.

The Money Advice Service also offers impartial advice and some simple guides about what to consider.

Meanwhile, particularly for those looking at buying annuities or finding a decent savings account or ISA for their retirement funds should seriously look into talking to financial planner.

Finally, anyone who thinks social or health care may be an issue in their future should take a look at our guide to that here.

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