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Part 2 of 3: Pension reform 2015

The pros and cons of the pension reform

About this article

In this second article on the new pension freedoms, we look at the investment opportunities now available to retirees as a result of the reforms, and the pros and cons of the different routes. But first, here’s a brief reminder of how the rule changes will affect the options available.

Recap

The pension freedoms introduced at the start of April handed savers unprecedented flexibility over how they spend their retirement pot. The changes mean anyone with a defined contribution pension – where employer and employee contributions are combined into an individual pot that the saver then has responsibility for in retirement – can take the lot as cash from age 55.

The only brakes on the system are a mandatory advice requirement for people with guaranteed pensions (primarily so-called defined benefit schemes) and the tax system.

Because pension withdrawals are taxed as income, anyone who decides to access their entire pot as cash risks being pushed into a higher income tax bracket.

So what are the options?

Because the reforms introduced in April hand savers total freedom, the options are limitless – Steve Webb, who was the pensions minister before he lost his seat at the general election, has even suggested the Government is comfortable with people splurging their savings on sports cars or exotic holidays.

But early analysis of consumer behaviours suggests most people will take their 25 per cent tax-free cash and leave the rest invested in drawdown. For many people this will be the sensible option – after all, despite the new freedoms, the purpose of a pension remains to provide a secure, decent income that lasts right through retirement.

Non-advised broker Hargreaves Lansdown says the four most popular retirement options in this brave new world are: withdraw funds from the pension and invest in cash, buy an annuity, purchase buy-to-let property, or run a drawdown investment portfolio.

Cash

Cash is familiar, simple and requires little management, so some investors might be tempted to strip the money out of their pension and stick it in a bank account or cash Isa. This may seem sensible now as inflation, which eats away at the value of money held in cash, hovers around 0 per cent. However, Hargreaves Lansdown senior analyst Laith Khalaf warns the current situation is unlikely to last.

“The current average interest rate on a deposit account is 0.8 per cent,” he says. “On a fixed rate bond the average is 2 per cent and on a cash Isa the average is 1.6 per cent. Inflation currently flatters these rates, with CPI standing as it does at 0 per cent, but this is unlikely to persist once the falling oil price falls out of the equation.”

Reform restrictions

Chancellor George Osborne said in his Budget speech in 2014 that, as a result of the changes to pensions, “no one will have to buy an annuity”. But that doesn’t mean that no one SHOULD buy an annuity. However, rates have been hammered in recent years, primarily as a result of the Government’s quantitative easing programme.

“Annuities offer pension savers a guaranteed income, paid for life,” Khalaf explains.
“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 per cent; the current inflation-linked rate is 3.3 per cent.”

Housing market implications?

Like cash, buy-to-let is expected to be a popular option for investors because it is tangible and people are familiar with it as an asset class. Furthermore, prices – particularly in London – have been surging in recent months, boosting investor confidence that, should they want to sell it on in the future, they will make a tidy profit. There are, however, no guarantees.

Khalaf says: “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.”
He says investors looking to get into the BTL market also need to be aware of the risk their property will not be occupied by a tenant.


“Vacancy periods should also be considered - currently a buy to let property is unoccupied for on average 3 weeks out of every 52,” he says. “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

Investing will be the favoured option for many savers because offers the potential to grow both capital and income over time, ahead of inflation. However, the world of investment is complex, with myriad costs, charges and risks that aren’t always clear at the outset. For many people – particularly those with a pension pot worth £100,000 plus – it is worth considering speaking to a qualified, regulated financial adviser before making any decisions. A list of local advisers can be found on www.unbiased.co.uk.

However, for those confident enough to go it alone, non-advised brokers such as Hargreaves Lansdown and Tilney BestInvest can help access a range of investment solutions.

Khalaf says: “Investing 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.”
To help investors getting started on the investment trail, Hargreaves has compiled a list of four funds that could be suitable for retirees entering drawdown.

Ecclesiastical Higher Income

Hargreaves Lansdown’s verdict: “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 per cent (variable, not guaranteed).

Marlborough Multi Cap Income

Hargreaves Lansdown’s verdict: “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 per cent (variable, not guaranteed).”

Newton Global Income

Hargreaves Lansdown’s verdict: “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 per cent (variable, not guaranteed).”

Woodford Equity Income

Hargreaves Lansdown’s verdict: “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 per cent (variable, not guaranteed).”

It should be noted that these funds are merely a selection of the thousands available to UK investors and, in reality, most investors will mix and match their portfolio based on the level of risk they are willing to take.

Investors could also opt for alternative investments outside funds looking to buy into UK companies. Experience Invest (full disclosure – they are paying me to write this article), for example, allow people to buy into income generating assets such as student property, off plan residential apartments and care homes on a buy to let basis.

Drawing the “natural yield”

Although investors may be tempted to take their entire pension pot in one go, this could leave them strapped for cash later in life. Experts recommend those who decide to stay invested draw the “natural yield” from their pot – dividends and interest accrued – and leave the initial capital untouched.

Khalaf says: “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.”

However, the drawback of this approach is that the starting level of income is likely to be low – typically 3 per cent to 4 per cent a year. “But the benefit is that can grow over time,” Khalaf says. “A £10,000 investment in Ecclesiastical Higher Income 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 per cent 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.”

Safe investment tips

With great freedom comes great responsibility – and great risks. Experts are already reporting a surge in activity from fraudsters looking to target older savers in the wake of the pension reforms. Many of these schemes, which often start with a cold-call, will promise gargantuan investment returns. However, in reality the asset may not exist or will be extremely risky.

Khalaf says: “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.”


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