Here's how to Brexit-proof your pension savings
The long-term impact on the nation’s personal finances of Brexit is uncertain, but for now the job of those investing for steady returns and income has been made harder.
The Bank of England last week resisted a cut in interest rates that some had forecast as a measure to fend off a slowdown in the economy following the vote to leave the EU.
It is too early to say a recession is coming, but a decline in confidence, an increase in uncertainty and reported delays to investment meant the bank had to weigh the potential economic benefit of making borrowing cheaper against calming concerns by maintaining the status quo.
Movements by Bank ratesetters affect the cost of mortgages, cash account interest and other financial products. In practice, however, these real-world rates move of their own accord – and have been falling even without a cut in the Bank Rate. We are now further away from rising interest rates than ever, and this is bad news for retirees who need income from their pension savings.
Returns from cash accounts continue to get worse and that has the effect of forcing returns on other types of assets lower because investors are willing to pay a higher price for any income on offer. The longer-term effects of the vote to leave the EU are still uncertain, but savers and investors, particularly those near or in retirement, should take stock and plan to Brexit-proof their finances.
Here’s our guide.
Income away from annuities
As expectations of a rise in interest rates diminish, yields on government bonds, also known as gilts, have fallen to historic lows. This has lowered the rates on annuities – the financial products that convert retirement savings into guaranteed income for life – because gilts are used to underpin their returns.
The chart below illustrates the relentless decline of annuity rates over almost 30 years. It shows the annual rate of return a 65-year-old man cashing in a £100,000 pension pot would have been able to receive for his money over that time.
How today’s retirees must envy the near 16pc returns available to their counterparts from 1990, though the earlier generation had to cope with inflation of almost 10pc.
With comparable annuities today paying below 5pc, retirees have a big incentive to avoid them if their circumstances allow. Pension reforms, which were introduced last year, make this possible for many more people.
Instead of being forced to buy an annuity, they can leave their pension invested, and draw down sums when they need the cash. But annuities are still the most appropriate option for many with “defined-contribution” pension savings as they provide a guaranteed level of income throughout their life.
“Those approaching retirement have never been faced with such stark choices,” according to Billy Burrows, of William Burrows Annuities.
“It is probably the worst ever time to buy an annuity, and delaying a purchase if you can will make sense for many.”
This will not be a comfortable choice for some. By delaying an annuity purchase you are hoping that rates will improve in the future. This is very uncertain and Brexit has arguably pushed any rise in rates and gilt yields further away.
It is possible that annuity rates will get worse before they get better. Yet retirees who delay annuity purchase could do better even if rates stay the same. If their health were to deteriorate significantly they may be able to buy an “enhanced” annuity that pays a higher rate on the basis that their life expectancy has reduced.
By delaying, however, retirees need to keep their pension savings in either cash accounts, where rates are minuscule, or invested in assets where there is a risk of price falls. Cash rates are unlikely to improve in the near term and so more risky assets, such as equity funds, will be necessary if retirees need a return from their pot.
A world of lower returns
If retirees can delay or avoid an annuity purchase, they still face investing markets that are stretched and uncertain. The vote to leave the EU has had a profound effect on the stock market.
The trend has been generally up – both the FTSE All Share and the FTSE 100 are higher now than before the referendum – but this rise hides great variations in the fortunes of different types of company.
Those firms exposed to the UK economy, which have generally enjoyed benign conditions until this year, have taken a turn for the worse as economists predict a domestic slowdown and possible recession.
Meanwhile, our largest companies, which have spent the past year coping with a slowdown in the global economy that threatens their overseas earnings, have become more attractive to investors as their earnings enjoy a boost thanks to falls in the pound.
For those investing now for retirement, this is a problem as those parts of the stock market that pay the bulk of dividends – typically large firms making goods that remain in demand whatever the economic weather – have been driven up in price.
Not only are these the firms likely to have been driven up by currency movements, but their shareholder payments are more attractive because income from cash and bonds is lower as interest rates have fallen, so their price goes higher still.
These are the companies that those in retirement need to pay them an income. With share prices this high, it is harder for funds investing for income to maintain yields.
If you live off investments, watch income closely
Even if you are happy to take the risk of leaving your pension pot invested, and have identified some assets you think can pay the income you need, you still face the danger that your money can run out too soon without close vigilance.
Mr Burrows said: “The effect of taking income in volatile markets is very real. People think they understand the risks, but it is completely different when you’re taking an income from your investments than it is when you are still saving.”
While anyone who invests pension money will be aware that they can suffer paper losses, they may not be aware of the damage that can be done when assets are sold at depressed prices in order to fund withdrawals. This effect is known as “pound cost ravaging”.
When markets fall, more shares or fund units need to be sold to generate a given level of income, so there are fewer assets left to take advantage of a rebound in prices. The 15 months since the introduction of pension freedoms reforms have illustrated the dangers that retirees withdrawing a pre-determined level of income can face.
Figures from William Burrows Annuities showed that savers with their money invested in the FTSE All Share will have seen their pot dwindle by more than 15pc in the time since.
Danny Cox, a financial planner at Hargreaves Lansdown, said: “The best way to ensure your pension lasts as long as you do is to stick to a natural yield approach. Withdrawing just the income generated by your investments leaves the underlying capital intact, improving the prospects for capital growth and a rising income over time.”
Check our five golden rules before you invest
This approach means only taking the dividends or bond interest produced naturally by your assets. This will leave the bulk of your capital intact, potentially until you die. Some may not wish to do this because they either cannot afford to live from such little income, or else because they are happy to run down their pot in later life.
That’s what it’s there for, after all. In these cases, it can be better to set withdrawal rates as a percentage of the overall pot, which means that lower sums are taken if the pot has shrunk, limiting the damage of falling prices.
Build a cash pot
You can’t protect against falls in asset prices – that is the risk of investing. It is possible, however, to prevent losses being crystallised by withdrawals if you maintain a cash pot that can be used for income. Mr Cox said: “The best long-term income drawdown investment strategy starts by building reserves of cash to help meet the first years of income plus a sum to allow for contingencies.”