Pension City, UK, is the gambling capital of the world. Forget Reno, Monte Carlo and Las Vegas. In Pension City, stakes are routinely in tens of thousands of pounds or more.
Many bets are placed without any understanding of the odds involved or that there are other games in town that might suit the gambler better.
That's why people in Pen sion City need sound financial advice. They have all reached retirement with money-purchase pension pots to invest but the range of options is bew ildering. Alarming numbers still choose a single-life level annuity without considering alternatives or even finding the best rate on the market.
In this series of articles, we will consider the options available to pensioners, concentra ting on the trade-off between risk and return that each offers. While there are many variants, we can divide the options into four main categories:
How ever, there are three clear trade-offs that a client has to consider.
First, there is the relative importance of death and survival benefits. A common criticism of annuities is that your pension dies with you. This can be mitigated by building in a guaranteed period and spouse's pension. Funda men tally, however, annuities ins ure you against living longer than your life expectancy and are not designed to return a fund when you die.
Income drawdown and pha sed retirement can provide a lump sum on death but, if you live to buy an annuity, you need good growth to offset the loss of mortality subsidy from those who die early – otherwise known as mortality drag. The mortality drag effect is greatest for drawdown bec ause you are normally buying annuities as you go along.
Those wanting to maxi mise death benefits normally choose income drawdown or phased retirement. In the short term, phased retirement should provide higher death benefits because the full value of the plan can be ret urned, normally tax-free. With drawdown there is a 35 per cent tax charge if the fund is paid out but, in the long run, it can provide better death benefits.
As more and more of the pha sed fund is used to buy annuities, the amount available on death falls so, even with the tax charge, drawdown eventually gives a higher cash payment.
Best of all for death benefits is a combined phased/drawdown plan but that is complex and potentially more expensive.
The second trade-off is between growth potential and income security. A conventional annuity guarantees your income but there is no possibility of investment growth. Unless you choose an annuity linked to the retail prices index, the buying power of your income is also vulnerable to high inflation.
An investment-linked ann uity gives growth potential,but with the risk that your income could go down at some stage.
The extent of this risk dep ends on the investment type you choose and whe ther you anticipate growth in your starting income.
Most investment-linked annuities are written on a with-profits basis,where guarantees and smoothing of ret urns offer some income sec urity. However, no plan guarantees your income will never fall.
Income from unit-linked ann uities is much more vola tile because your pension is linked dire ctly to stockmarket returns.
Phased retirement and income drawdown generally carry a higher investment risk than annuities because you need high equity content to offset the effect of charges and mortality drag. You are also vulnerable to changes in annuity rates.
It is essential that cli ents investing in these options understand the risks involved.
The final trade-off is bet ween current income and fut ure income. With a con ventional annuity, you can choose a level pension or an escalating one starting at a lower level, while inv es tment-linked annuities usually allow you to inc re ase your starting pension by anticipating future growth.
With both, it is normally a once-for-all choice alth ough some investment-linked annuities allow you to review it later.
With phased retirement and income drawdown, you can manage your inc ome level much more act ively and can adjust it if, for example, early investment returns are dis app ointing. Again, phased retirement gives greater flexibility early on but, when the bulk of the phased fund has been converted to annuities, it is less flexible than drawdown.
In all cases, though, the higher your income at the start, the less pension you are likely to receive later. It does not necessarily follow, however, that cautious cli ents should choose a low starting level of income. They could instead start at a reasonably high level and invest what they do not need in a different vehicle, such as an Isa.
This could have particular attractions for drawdown cli ents unhappy at having to buy an annuity by 75.
By taking higher income from the plan and investing it, they can build up a substantial fund that they can draw from later as they need it, with a cor res pon dingly smaller amount coming from an annuity.
If this strategy is adop ted, it must be very clearly documented to avoid problems if the pension income does fall at some stage.
It also requires a certain amount of discipline to ensure the extra income is invested rather than spent in the early years.
We will return to many of these issues later in this ser ies of articles.
For now, though, the clear message is that the choice faced by new pensioners is often a complex one and we cannot afford a one -size-fits-all approach to retirement planning.