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Categorized | Insurance

How best to take income in retirement

Posted on September 21, 2016

Elderly pedestrians walk using walking sticks on Eastbourne Pier in Eastbourne, U.K., on Monday, Aug. 22, 2016. Pensions are looking like an economic time bomb for Britain, meaning investors had better watch how the nation tries to defuse it. Photographer: Matthew Lloyd/Bloomberg©Bloomberg

Three key factors have changed the retirement income equation in recent times, which in turn have had knock-on implications for retiring investors.

First, pension freedoms. The government has abolished the near-requirement to buy an annuity, meaning investors can run their pension investment portfolios on an open-ended basis, drawing down an income from the funds with no fixed end date. In the past, there was an effective cut-off point of age 75.

    Second, the taxation of death benefits has been turned on its head. In the past, investors could only pass undrawn pension benefits to dependants, with payments to non-dependants or a lump sum payout being taxed at 55 per cent. From April 2015, death before age 75 means pension assets being passed on to beneficiaries of the member’s choice, dependants or otherwise, entirely tax free. Death after age 75 now only means income tax being paid by the beneficiaries when they come to take money out of the pension system. There is no inheritance tax payable, meaning for pension investors who are affected by this wealth tax, money passed from a pension is potentially worth more than other wealth.

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    And third, the annuity market is experiencing an implosion. Annuity rates have been on something of a death spiral in recent years and after the Brexit referendum result, there are signs of a crisis being reached. Prudential has pulled out of offering open market annuity terms altogether, now only selling them to their own internal customers. LV= has raised the minimum annuity purchase price to £25,000 and some annuity providers have seen their share prices collapse in recent months. In spite of the fact that many investors would benefit from having some secure guaranteed income, increasing numbers of investors are baulking at the price, choosing instead to keep their money invested in the markets.

    Meanwhile, there is no default drawdown product which can pay out a secure, predictable retirement income, giving investors the benefit of equity market returns whilst protecting them from downside risk. Drawdown may be the preferred option for increasing numbers of investors but it is far from risk free. The most reliable solution is to draw the natural yield from your investments. If you invest in a basket of equity income funds, with perhaps an element of strategic bond investment thrown in, you would be looking at an income in the region of 3.6 per cent a year. The downsides to this are twofold. First, many people want a higher rate of income. Second, you’ll die with your funds still intact. But for some investors, this preservation of pension wealth may be no bad thing.

    What’s more, taking the natural yield delivers a robust inflation-proof income over time. Going back over nearly 30 years, if you had started taking the dividends from an equity portfolio in 1989, you would have received an income of just under 4 per cent of your portfolio. Today you would be getting an annual income of the equivalent of about 12 per cent of the capital sum you had originally invested. The worst drop in income you would have seen would have been 21 per cent in 2009, but by 2012 it would have recovered and passed the level of three years earlier.

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    So drawdown providing an income from equities can be a reliable way to receive a rising income. When you die, the worst that will happen is that your beneficiaries pay income tax on any withdrawals from the funds you pass on; though if you die before the age of 75 it is tax free. This means for many investors that preserving money in a pension into later life makes sense. If you want some certainty of income, however, it may make sense to sacrifice some capital for an annuity.

    Whether you want to run down other assets, such as money accumulated in Isas or your property, may well depend on your overall inheritance tax (IHT) position. If you are likely to be liable for IHT, then you may be better served by running down your Isas ahead of your pension.

    Inheritance tax planning is a complex area, so if you’re in any doubt as to how the rules might affect you, or how best to draw a retirement income, paying for some financial advice would be a wise investment.

    Tom McPhail is head of retirement policy at Hargreaves Lansdown