What is it about pensioners and parachutes? We turn 55 and feel suddenly compelled to fling ourselves from high places strapped to an outsized duvet cover. But by a neat coincidence, skydiving can teach us a crucial lesson about retirement.
Picture the scene. You’re hurtling down at 120mph towards terra firma (and it does look very firm and terror is very much involved) when your instructor pulls the rip-cord. Colourful canvas billows above you, and the last stage of your earthbound journey is a gentle glide. Many describe it as the thrill of a lifetime – so long as you remember to pack your parachute.
Now picture another scene. You’re in your mid-80s, and the balance of your pension pot is hurtling down towards zero. The drawdown scheme you chose in your 60s has lasted pretty well throughout your retirement, but realistically has only a couple of years’ worth of funds left in it. The good news (which is also bad news) is that you feel fit and healthy, with at least ten more years left in you. The fact is, when you were spending your pension savings, you never really expected to live this long. Now you’re looking at perhaps a decade of living off nothing more than the state pension (around £8,000 a year at most). In short, you come down to earth with a bump.
The classic pension dilemma
This predicament sums up the whole pension conundrum. People want flexibility and choice over how they spend their savings, but they also want (or rather, need) financial security to last their whole lives. Pension freedom has done a good job of addressing the first issue, but arguably at the expense of the second. When people opt for drawdown – taking income from a finite pension pot that remains invested – there is a very real risk that they will outlive their savings and spend their last years in poverty.
Life expectancy in the UK has risen dramatically – there are now more than half a million Britons aged over 90, and the number of people living to 100 has risen by 72 per cent in the last decade. So if you start a drawdown scheme at 65, you will want it to last at least 20 years and probably nearer 30 – and you may live even longer.
Compulsory annuities – the bad old days?
It used to be the case that most people simply had to buy an annuity – an insurance product that would guarantee them an income for life. No-one wants a return to those days before pension freedom, but some prominent voices have been calling for a softer version of this rule to be introduced.
Retirement expert John Ralfe has championed the idea of ‘deferred annuities’. Popular in the US but not generally offered here, a deferred annuity is one that starts paying out only in later life, such as when you reach your mid-80s. Mr Ralfe has lobbied the government to make such an annuity mandatory, to ensure that everyone receives a guaranteed income to supplement their state pension, even after their savings run out.
Never run out of money
The case of putting guaranteed income in place for your later years is a strong one. Annuities slumped in popularity when pension freedom was introduced, and today’s low annuity rates are also putting some people off the idea. Deferred annuities may seem even less appealing in the post-freedom world: you might not like the idea of buying something up-front that would only start paying out about two decades later, assuming you live that long.
So far there’s no sign of deferred annuities catching on in this country. So why mention them at all? Because the core benefit of annuities is still compelling: they keep on paying out no matter how long you live. And the argument for having an annuity in later life, when your other funds may have run out, is even stronger.
There are ways you can set up your pension to do a similar job to a deferred annuity, without locking your money out of reach.
Make your own ‘deferred annuity’
Suppose you wanted to take most of your pension savings as flexible income, but build in security for the future at the same time. One way to do this might be to set aside some of your pension pot at the outset, leaving it outside your drawdown fund.
This set-aside portion of your pension could be invested for growth – much as it would have been before your retirement. The idea is that you wouldn’t touch it until a certain age (such as 85) or in the event that your drawdown fund was exhausted.
You could then use this second-stage fund to buy an annuity. Why might this be better than buying an annuity straight off? Firstly, you would have had the flexibility of drawdown up to this point. Secondly, although annuity rates are very low now, they may be higher in the future, giving you better value for money. Thirdly, you would be older, so the annuity wouldn’t have to pay out for as long – which again would make it cheaper. Fourthly, you may also have health conditions or other life circumstances which entitle you to an enhanced annuity (i.e. one that pays a better rate).
The other good reason to set aside a portion of your pension at the outset (rather than use what remains of your drawdown fund) is that a pension invested with the specific goal of buying an annuity will be managed very differently from one designed to produce an income in drawdown. You are therefore more likely to achieve better results by planning ahead in this way.
Deploying your pension parachute
Retirement can be a long time – almost as long as the time you spent in employment. Most pensioners are shrewd enough to spend carefully and make their pensions last. However, many will still be caught unawares by their own long lives.
A spending plan is hard to make when you don’t know how long your money needs to last. Setting up a later-life annuity fund can deliver some certainty. If you know your drawdown fund only needs to last about 20 or 25 years, you can manage your income more confidently. When the fund is empty, you simply pull the rip-cord – and use your second-stage pension fund to buy the annuity that will see you to the end of your life.
Uncertainty isn’t an argument against drawdown schemes, any more than the risks of skydiving should stop anyone from giving it a go. In both cases, all you need to do is remember to pack your parachute.
If this article has helped to give you some ideas, the best thing to do is contact a financial adviser who can give you proper advice tailored to your circumstances.
This article was first published by unbiased on the 30th August 2016.