The combination of longer lifespans and new pension freedoms has turned the way we need to plan for retirement on its head.
The freedom and choice reforms are now tearing up the traditional covenant between the government and savers. For generations, pensions have been structured as ‘a double-edged incentive’; in return for the big carrot of full tax relief on contributions, there were strict rules to ensure that savers would not later become reliant on the state (notably the obligation to buy an annuity). The new freedoms have changed that deal by giving people more flexible access to their pension pots, so they can now invest or spend them as they wish after the age of 55.
This is a big positive. The old system was designed for a previous age and the way people retire now is very different. However, with wider choice comes the need for much more education, guidance and support.
The conventional wisdom was that an individual would draw on your pension for income, and plan to pass on other assets to their heirs. Now, it may make more sense to draw down retirement income from assets outside of their pension, such as individual savings accounts (Isas) or tax-efficient bonds.
However, there is a catch. In recent years, the amount someone can save into a pension has been progressively reduced. In 2008, you could pay £275,000 annually into a fund; the maximum now is £40,000. The total value of savings you can hold in a pension fund has also been reduced dramatically. From next April, it will fall from £1.25m to £1m, with any assets above that taxed at a punitive 55% rate. The trick is to get as close to this target as possible, without tipping beyond it. It’s like a Mission Impossible scenario; individuals will need to weigh up all the various drawdown options, as well as the merits of other tax-efficient investments.
Rising life expectancy has also altered the picture hugely; a 25 year old today might expect to live until 88. That probably means a much longer retirement, in turn, heightening longevity risk, that is the possibility of running out of money before death.
But it also means that the period for pension savings has become markedly longer. For a 25 year old, we’re talking a possible 63-year term. That has big implications for the mix of assets they may want to put into a pension fund and the investment strategy going forward.
For example, depending on their risk profile, a 25 year old might choose to invest 80% in equities when they start saving. The risks are higher but so are the probable returns and, with time on their side, they can weather fluctuations in the market cycle. By the time they hit their 60s though, they’ll need to start taking out some of the risk and become more ‘defensive’, while keeping an eye on the fact that their fund has to last them for the next 30 years. It’s a tricky balance to get right.
The reforms and the option of drawdown mean that the end game is no longer the point of retirement, it’s the end of life. The old cliché applies: it’s not timing the market, but time in the market that counts.
Andy Cumming is head of advice at Close Brothers Asset Management
