Those saving for retirement might reasonably ask what the financial fuss is about Brexit. The fall in the value of the pound following the surprise referendum result gave a helpful boost of 10 per cent or more to international assets such as global equities. After an initial wobble the UK equity market has bounced back strongly and the fixed income market has also seen quite a surge, with long-dated gilts having jumped by nearly 15 per cent in the past few months.
The people that will be feeling the pinch, however, are that small but significant group of consumers looking to guarantee a lifetime income from their pension savings. It seems every time anybody suggests annuity rates cannot go any lower they lurch south again. At the time of writing, the best rate for a 65-year-old seeking a level guaranteed income for life is not much over 4.5 per cent, having been around 5.9 per cent a year ago.
We have a general rule that you should have enough guaranteed income to cover your essential expenses. Not only does this give you peace of mind but it allows you to take on more investment risk with the rest of your savings. At these rates I am sure most would be hard pushed to recommend an annuity to all but the most cautious of customers. So what are the alternatives?
Clearly, looking at a temporary annuity will provide certainty of income for a fixed period and avoid having to permanently lock into these low rates. But temporary annuities have also been thumped by the interest rate fall and so offer little in the way of meaningful returns.
For more adventurous clients, staying invested is of course an option and diversified income funds should offer a reasonable yield with some downside protection. But with asset prices at these high levels, the risk of loss of capital will be heightened and advisers will need to make sure the funds they choose are managing downside risk as well as delivering yield. There is a huge divergence of approaches across the income sectors, so making the right choice is essential.
A more certain method of improving income would be to look at other sources of retirement income and, in particular, the terms of any defined benefit pension the customer has. The rate at which pension funds convert pension income to tax-free cash can differ significantly from what would be considered fair value on the open market.
Even in more normal interest rate environments those needing guaranteed income will often be better served by foregoing tax-free cash for income from their DB plan and drawing down cash from their other savings. Of course, the pension income is taxable but, even so, the trade can be worth doing. To the extent that actuarial factors have not yet been updated to reflect the latest fall in rates the terms of this deal could be very attractive.
Then there is the option to defer state pension and draw down the equivalent cash value from the pension fund. I hesitate to mention this in these pages as I know many advisers insist it is poor value. This is often based on the fact missing out on a year’s payment in return for the 5.8 per cent uplift will mean staying alive until you break even. This is a fair challenge but when considered in comparison with an annuity, the effective conversion rate is very favourable. Deferring state pension is equivalent to buying an annuity – it is just the Government that wins if you die early, not an insurance company.
Consider deferring for just a year. Assuming the new state pension of £8,120, deferring will lift the pension by 5.8 per cent or £471 a year from next year. So in effect you have “bought” an annuity of £471 a year from age 66 and it is subject to the triple-lock – for the moment at least. The “cost” of this is that you have to fund the state pension (plus the 5.8 per cent uplift) for this year. That costs £8,591. If you bought an inflation-linked annuity of £471 from age 66 on today’s rates you would be looking at a cost of just over £18,000. That is more than twice the price of the deferral cost.
Finally, while it may be small beer, those over state pension age can also buy additional state pension of up to £25 a week. For a 66-year-old male an additional £25 a week costs only £21,775 – an implied annuity rate of 6 per cent compared to the effective open market rate for index-linked income of 2.6 per cent. If you are in the market for secure income, the Government is still the most cost-effective provider.
Who knows where we are going over the coming years in terms of retirement options. What is clear is that clients are going to have to be even more imaginative about where their income will come from. As always, advisers are going to be at the forefront of helping them make the right choices.
Richard Parkin is head of pensions policy at Fidelity International