Pensions….how much is enough?

So here’s the deal….

I’m 57. Gill’s 52. We’re on a break. No, not on a Ross & Rachel Friends break. A work break. Early retirement. A hiatus. A mature gap year.

And that’s the thing…we’re not really sure ourselves yet how long this intermission might last.

How come?

Pensions. How the *&^% do we know if we’ve got enough to get us through however long we need to get through, in the lifestyle and financial comfort that we’d like to get through it in?

We’ve been lucky – and sensible – enough to stash away some savings in a tax-efficient SIPP for the last 15 years, alongside paying off the mortgage. Largely thanks to what I earned and learned working for The Motley Fool and lovemoney.com, Gill’s hard work building up South Minster Kitchens, and using Hargreaves Lansdown’s excellent guidance and online platform to manage our pension savings. And not having children made a huge financial difference. And being teetotal and never going out, obviously.

Until fairly recently, your pension choices were limited, but clearer. Work until 65 for men, 60 for women. Start collecting your state pension from the Post Office every week (along with those really nice mint humbugs), and additionally – if you were lucky – get a monthly, fixed pension from where you worked for 40 years. And oh yes, it probably increased every year automatically, in line with inflation. And that occupational pension scheme income would probably have been a function of your final salary before retirement, rather than a measure of  how much your actual contributions ( personal and employer) had grown to. Not that I’m bitter, or anything.

Ah, how simple things were. Like having only 3 or 4 TV channels to choose from. Or deciding whether to go for a bottle of Liebfraumilch, or that exciting new slightly fizzy Lambrusco wine.

The recent changes to pensions have added flexibility and complexity to that simple – but outdated – view of pensions in retirement. And the further changes proposed by the current government to take effect in April 2015 will provide even more flexibility.

But here’s the quandary Gill and I have to wrestle with now…

  • we’ve got a defined contribution (aka money purchase) pension pot
  • we just missed out on the defined benefit (aka final salary) pension scheme era, giving a decent fixed inflation-linked income for life and certainty over your financial future in retirement
  • I won’t start collecting my state pension until 2023, when I’m 66. Gill will have to wait even longer, until 2029, when she’s 67.  And there’s every chance the dates will be pushed back even further before we get there. If we get there…
  • I’m over 55 so I can take 25% out of my own pension pot now, free of tax. Very nice, but without a current income for either of us that one-off lump sum will have to put food on the table, pay the council tax, and finance any of the fun stuff that we’d like to do while we decide what to do with the rest of our ageing lives
  • we could take an annuity from our current private pension pots. But because of  the prevailing global financial position and interest rate environment, annuity rates have been running at, or near, historic lows
  • for £100,000 saved in a defined contribution pension pot, I’d get roughly £400 a month or £4,800 a year, if I were to swap the remainder of my pension pot for an annuity now – ie an annual return of 4.8%, before tax. And that’s NOT inflation proofed and Gill would get NOTHING after I’ve popped my slightly older clogs
  • it gets worse. I’d only get an annuity income of around £200 a month or £2,400 a year now for £100,000 of pension savings – ie 2.4% return before tax, if I want to protect against the risk of inflation eroding my income and ensure Gill gets 50% of that meagre annuity income once I’ve snuffed it
  • so simplistically that would mean I would have to stick around a long time to make sure I got my money back from the annuity provider to whom I “sold” the pension pot

The only advantage of an annuity that I can see at these levels of return is certainty. You’ll know exactly what your income is for as long as you stay above ground.

Fortunately there is now an alternative. It’s called income drawdown. How does it work?

  • you leave your defined contribution/money purchase pension funds invested, without buying a fixed income annuity
  • you can take out a flexible income, based on what you need and subject at the moment to certain statutory limits (to make sure you don’t spend it all too quickly on fripperies and throw yourself on the mercy of the state too soon…but these restrictions could be lifted next April, and you would then be able to spend the lot on fripperies  and throw yourself on the mercy of the state)
  • the main risk of going into income drawdown is that your pension pot remains invested, so it is subject to market fluctuations – depending how you decide to leave it invested – and your income is not guaranteed

The other great unknown for an income drawdown pension is life expectancy. How long have you got left? The current risk adjusted life expectancy for me is 84, so let’s say another 27 years…..possibly more if I stay really fit and cut out that regular Friday night curry. And let’s say Gill lives to 86, that’s another 34 years for her…maybe closer to 40 if she’s anything like her Nan.

Can we really eke out our current pension pots for that long?

Despite the risks, I think I still find the income drawdown route more attractive than taking out an annuity. It puts quite a burden on you to make the right investment decisions, and not spend beyond your pensioned means, but at least it’s flexible and largely in your control. It is your hard-earned money, after all, and the current government’s attempts to recognise that are to be applauded.

I’ve highlighted some of the decision-making quandaries above, but I’ve still only really scratched the surface of things to think about in making such an important decision.

Why not take a mixture of guaranteed annuity and flexible drawdown income? What are all the other tax considerations, based on current legislation and also after the proposed changes due in April 2015? And what happens to our remaining pension pots, once we’ve both shuffled off our mortal coils, in any of these very different scenarios?

And there’s much, much more to ponder…but the greatest unknown remains the question of life expectancy. How galling would it be for us both to kick the bucket in 5 years time – tragically both crashing on the rocks during a cliff diving competition in Mexico – having taken out an annuity, so that the insurance company enjoys the fruits of our long labours more than we have?

Or if we go the income drawdown route and, thanks to healthy Madonna-like macrobiotic diets and staying fitter than a bunch of butchers’ dogs, both get telegrams from King William….but have run out of pension pot dosh at some time in our energetic 90s?

And there’s the rub. There are just too many variables to be able to make an absolutely correct decision NOW. Unless of course, you know that you’re definitely going to fall off your perch at 9 o’clock on Saturday night, just after Strictly, on 24th October 2026. Then you can really plan ahead, and cut your pension cloth accordingly.

I’ll write again on this mystical subject of pensions and let you know which options we follow, but for now I hope this article has at least highlighted some of the considerations we – and others – face approaching those allegedly golden years of retirement….

“You can always alter and adapt your plan….provided you have one.”
Manoj Arora, From the Rat Race to Financial Freedom

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