1st April 2015
One of the biggest changes to the UK pension system takes place next Monday, as millions of savers will for the first time have total control over their pension pots. Hargreaves Lansdown, the adviser, explains how savers can make best use of their newfound freedom, how to invest for drawdown and how to stay safe from scams….
“The new pension freedoms present both a threat and an opportunity,” says Laith Khalaf, senior analyst at Hargreaves Lansdown. “Savers finally have the flexibility to decide the size and shape of their retirement income, but if they aren’t properly prepared, they may make decisions which are hazardous to their retirement health.
“Using a drawdown plan in retirement is strictly for those who are willing to choose their own investments and regularly review them, or who pay an adviser to do this for them. Anyone who is not comfortable with this approach should consider other options for their retirement funds.
“The key risk of pension freedom is running out of money prematurely. This can be mitigated by hitting retirement with a big enough pension pot, drawing the natural yield from your investment portfolio, and using an annuity to secure a basic level of income for life.
“Fraudsters pose another big risk to pension savers. They are no doubt licking their lips at the prospect of billions of pounds being unlocked from next Monday. Investment products which promise the earth are likely to be a key form of attack for these scam merchants. Investors should be extra vigilant for this sort of activity when it comes to their pensions. They should only deal with firms that are regulated by the FCA. Generally if something sounds too good to be true, it probably is.”
Why invest in retirement?
Pension savers face a wide choice of options with their retirement pots from next Monday. The four most popular options are likely to be:
1. Withdraw funds from the pension and hold cash
2. Buy an annuity
3. Withdraw funds and purchase a buy to let property
4. Run a drawdown investment portfolio
Each of these methods has pros and cons, and will appeal to different people depending on their interests and aptitudes. Nor are they mutually exclusive, so pension savers can combine approaches. It helps to consider the benefits and potential risks of investing in the context of the other options available to retiring pension savers.
Cash is simple and it requires little management. However there is a high risk that the buying power of your pension pot will be eroded by inflation over time. The current average interest rate on a deposit account is 0.8%. On a fixed rate bond the average is 2% and on a Cash ISA the average is 1.6%. Inflation currently flatters these rates, with CPI standing as it does at 0%, but this is unlikely to persist once the falling oil price falls out of the equation.
Annuities offer pension savers a guaranteed income, paid for life. While they are unpopular because they are inflexible, and you lose access to your capital, the security provided by annuities should not be under-estimated. An annuity should certainly figure in everyone’s considerations at retirement, even if it’s only for part of their pension pot. The current level annuity rate for a 65 year old man is 5.6%; the current inflation-linked rate is 3.3%.
Buy to let gives pension savers an income stream with the potential for capital growth over the long term. However the costs of buying and administering a property are high, and include stamp duty, legal fees and maintenance which all eat into returns. Vacancy periods should also be considered – currently a buy to let property is unoccupied for on average 3 weeks out of every 52. You also may have to withdraw a large sum from your pension in one go, to fund the property purchase, which could incur avoidable tax bills. This approach also puts a lot of eggs in one basket, which is determined by conditions in the local property market.
Investing gives you the potential for both your capital and income to grow over time, ahead of inflation. It also gives you the flexibility to access your capital as and when you want it, and to draw your pension gradually while minimising the tax you pay. The risk is you lose money, though the longer you invest for, the lesser this risk. You must be willing to tolerate a variable income, which will fall in some years. Indeed there may be times when it is prudent to stop making withdrawals altogether. You also need to be willing to review your portfolio regularly in order to make sure it’s performing as expected, and your income needs are still met by your portfolio.
Protect your investment gains from tax
If you are investing in retirement, doing so within the pension wrapper means your investments grow sheltered from income tax, and capital gains tax. You can do this either through a drawdown plan, or through an UFPLS – Uncrystallised Funds Pension Lump Sum.
Drawing money out of the pension and running a standalone investment portfolio means your income is subject to tax at your marginal rate, and you may face capital gains tax on profits. You may also incur Inheritance Tax which might be avoided if funds are kept inside the pension.
Drawing the natural yield
Our preferred approach to running a drawdown plan is for investors to draw the natural yield of dividends and interest from their portfolio. This leaves their capital intact to draw on later in retirement, and helps to grow their income over time. If you are regularly withdrawing capital from your plan, you are also chipping away at the source of your income.
The natural yield approach does mean starting with a lower level of income – typically 3% to 4% a year. But the benefit is that can grow over time. A £10,000 investment in Ecclesiastical Higher Income (see below) in 1994 would initially have paid you an annual income of £400 in the first year. If you drew the natural yield from this fund each year, it would now be paying you £1,150 a year, or 11.5% of your initial investment.
Investors who want to draw more than the natural yield from a drawdown portfolio need to tread with caution. While this approach may be appropriate in later retirement, high withdrawals in the early years combined with falling markets can be a recipe for disaster.
Four fund ideas for drawdown
Ecclesiastical Higher Income. A little-known fund with a long and illustrious track record. This is actually a balanced managed fund; it invests predominantly in equities, with some fixed interest to reduce volatility. Robin Hepworth, who runs the fund, looks for companies with a healthy yield he can invest in for the very long term. He has continuously held some of the companies he put money in when this fund was launched in 1994, including GlaxoSmithKline, BP and Shell. The current yield on the fund is 4.2% (variable, not guaranteed).
Marlborough Multi Cap Income. This fund offers investors a different take on the traditional UK Equity Income fund. Most funds in this space invest in the big blue chips of the FTSE 100, while this one prefers to look for opportunities amongst the UK’s medium and smaller cap companies. These companies present a fertile hunting ground for seasoned stock pickers like Giles Hargeave and Siddarth Chand Lall, who run the Marlborough fund. The yield on the fund currently stands at 4.1% (variable, not guaranteed).
Newton Global Income. A growing pool of overseas dividend-paying companies provide a rich universe for fund manager James Harries and his team to pick from. The Newton team identify global themes they believe will shape the investment landscape, and invest in companies which stand to benefit. The fund currently yields 3.5% (variable, not guaranteed).
Woodford Equity Income. Neil Woodford is a contrarian buy and hold investor who is not afraid to step out of line with his peers. This approach led him to shun tech stocks in the late 1990s and banks in the run up to the financial crisis, shortly before these sectors sold off sharply. As a custodian of long term retirement funds there can be few better candidates. The current yield on the fund is 4% (variable, not guaranteed).
BEWARE! Investment scams will be the new pension liberators
For several years now pension liberators have targeted savers’ pension pots with the lure of unlocking their pension fund as a cash lump sum. Now the government is giving savers access to their pensions, these fraudsters are going to have to change tack.
One of their new tactics is likely to be tempting people to withdraw funds from their pension to put into investments which make lots of tempting promises. Offers of guaranteed double digit investment returns should be treated with extreme suspicion.
Investors should make sure they only deal with reputable companies who are regulated by the Financial Conduct Authority.