Mark Dampier: Pension freedom is coming - how comfortably does it sit with you?

 

This week I have departed from looking at an individual fund. Instead, I have decided to focus on the forthcoming "Pension Freedom Day".

Presently, there are two main choices for pension investors: an annuity or income drawdown. In the case of the former, a regular income is bought from an insurer using your pension fund when you choose to retire. This means you are in effect giving up your capital to an insurance company in return for a secure income.

Alternatively, income drawdown allows you to choose where you invest your capital. Investors then draw a variable income directly from this pension pot, currently within limits set by the Government.

From 6 April 2015, pension investors will be able to take their entire pension in one go, 75 per cent of which will be subject to income tax, and use it exactly as they wish. The move has undoubtedly been popular – I have met few clients who have ever loved annuities, even when they were sporting yields of 10 per cent or more. With interest rates and gilt yields now at all-time lows, it is no wonder the Government's new legislation has been welcomed.

Freedom is a wonderful notion, providing you know what to do with it. More choice is usually welcome, but it does come with the need to be more informed.

In my view, choice is only really available to those with a large pot of money. I suspect those with accumulated sums of around £20,000 to £30,000 will look to withdraw most of this money, although they would need to watch the potential tax consequences.

I expect those with at least £100,000 or more will consider income drawdown. This sum, however, should not be considered in isolation and a decision should also be based on other monies you might have accumulated. Some investors may have a smaller pension, but alongside an additional sum of money, perhaps from a business or inheritance. This, in turn, offers more choice.

I would suggest starting by calculating your post-retirement budget, including all necessary living expenses, insurance contributions, and so on, before working out what an annuity might pay. An annual living expense of £15,000 is not unreasonable. However, this would require a capital sum of around £300,000 to be invested into a pension.

My main worry about drawdown is that most investors will want to draw more than the available annuity rate, which at present is around 5 per cent. Here, your presumption is that you are able to select an investment that will yield more than this; otherwise you will end up eating into the original capital invested to make up for the shortfall. It is quite possible you can make more than the required amount. However, while stock markets have their good years, they also have their bad years.

It is the bad years that concern me. If you draw on your capital even in a falling market, the original invested sum can quickly diminish. Most people are expected to live 20 years in retirement and it is likely you will witness a stock market slump at some stage. Even the most diversified portfolios could see a substantial fall in value.

The question you have to ask is: can you afford to stop making withdrawals until the capital recovers? An alternative is to take only the natural income from the portfolio in the interim, though this is likely to be around half what you would get from an annuity. For many, it simply would not be enough.

In conclusion, use the new pension freedoms carefully. Make haste slowly. Ensure you understand the risks of using income drawdown before deciding to ignore annuities – although I appreciate that it hardly seems the best time to buy an annuity in an environment of historically-low interest rates.

One choice, if you have it, is to delay buying an annuity until rates improve. Yet predicting the first rate rise is almost as difficult as foretelling the fortunes of the stock market. All in all, this is a far trickier area than many people appreciate – I suggest considering all avenues before coming to any firm decisions.

Mark Dampier is head of research at Hargreaves Lansdown, the asset manager, financial adviser and stockbroker. For more details about the funds in this column, visit www.hl.co.uk

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