How to construct a ‘last wage lite’ pension: ANDREW OXLADE
Today it’s hard to find anyone outside the public sector who can still pay into a final salary pension.
Try asking around your wider friend group. I’ve found one, and even he is being transferred from ‘defined benefit’ to the far more common ‘defined contribution’ pension.
Like the rest of us, he will now be required to pay money into a pot, along with employer contributions, and hope it grows to a size that will cover his full retirement.
The final salary pension already accrued will make that significantly easier.
Final salary pensions were treasured for many reasons. Firstly, you knew the retirement salary you’d get, as the name suggests. Secondly, that income would rise with inflation.
Top draw: A final salary pension pot with its guaranteed retirement income is the best you can get but almost no private sector employers still offer this
An annuity can be ‘final salary lite’
Imagine if such a pension product was available today, and available to all. Well, there is. But it’s not loved. In fact, it’s very much unloved. I am talking, of course, about annuities.
You hand over money to an insurance company and they will pay you an agreed income each month or year. On an annuity rate of 6.5 per cent, you’d pay £100,000 and get £6,500 a year.
You can add inflation protection, so the income rises with inflation. But it will start at a far lower level.
Like a final salary pension, you know what you’ll get throughout retirement and you know that it will rise with inflation.
Yet the pariah status of annuities remains alive and well. It hit home at a recent panel discussion where I was talking about early retirement. My fellow panellist delivered a brutal valedictory on the wrongs of annuities, met by many audience nods.
History explains why. Before 2015, most of us were compelled to buy an annuity with our pensions. Hence the celebrations when compulsion was removed for all, enabling us to go out and ‘buy Lamborghinis’, if we so wanted (a dry comment from the pensions minster at the time, Steve Webb – now This is Money’s retirement columnist).
We didn’t and haven’t. But we had the choice.
Meanwhile, the anti-annuity sentiment gathered pace. Annuity rates, which were already low at the time, fell even further. This is because annuity pricing is led by the government’s cost of borrowing. As this fell throughout the 2010s so did the income that an annuity could buy.
Back on the up Annuity rates are driven by gilt yields – the measure of the cost of UK government borrowing – and the 15-year gilt yield has risen substantially
The renaissance of annuities
But fast forward to today and much is changing on annuities.
This began as interest rates climbed and took off when Liz Truss’s mini-budget of 2022 sent government borrowing rates soaring, and therefore annuity rates.
The purchasing power of £100,000 for a 65-year-old, without inflation protection, surged from an annual income of around £5,000 to around £7,500.
Some shrewd buyers picked up a bargain, buying certain income that might exceed uncertain returns of the stock market – a rare opportunity.
Industry figures point to a renaissance in the popularity of annuities as rates have improved.
Sales rose 39 per cent in the last financial year, according to figures recently published by the Financial Conduct Authority.
Rates may be about to rise further due to moves in gilt pricing. The crucial 15-year gilt yield, which influences annuity pricing, has risen from a whisker above 4 per cent three weeks ago to around 4.5 per cent.
The chart above shows the longer history of the 15-year gilt yield.
Annuities vs income drawdown
Perhaps the Autumn Budget will further steer the debate on the merits of annuities.
An alternative to buying an annuity is to stay invested and take an income from your investments.
This can be done via regular ‘drawdown’ income payments or though lump-sums.
If all goes well, you get a decent income without diminishing the pot and it can, on your death, be bequeathed to your beneficiaries free of inheritance tax.
Albeit, if you die after the age of 75, those inheriting it will pay income tax on withdrawals.
And by keeping the pot intact, not sold for an annuity, you can dip into it for emergencies, such as private healthcare, and so on.
But the inheritance exemption that exists on pension is said to be one of the Treasury’s targets in the Autumn Budget.
If pensions were moved into the inheritance tax net, it would remove one of the perks of staying invested, at least for the wealthiest investors.
Bear in mind that only 4 per cent of estates are liable to inheritance tax today. The figure is expected to rise sharply but would rise faster if pensions were caught in the net.
Such a move would face fierce opposition, so we’ll have to wait and see what Rachel Reeves does on October 30.
Even if the change is made, income drawdown will maintain its primary appeal given the flexibility it offers.
Annuities, however, may play a greater role in retirement plans with the ‘bit of both approach’ gaining in popularity.
The plethora of annuity options are not always understood. You can buy an annuity for a fixed period rather than for life, for example.
You can also include an income for your spouse after your death. You get a better income if you declare certain health issues. And buying later, perhaps in your 70s or 80s, will achieve a far higher income – a £100,000 inflation-linked annuity at age 65 buys £5,161 a year, or £7,595 at age 75, according to data from the retirement specialist HUB Financial Solutions.
For some – particularly those who overly worry about investment ups and downs – a hybrid route may have appeal. You could, for example, cover all basic expenses with an annuity while keeping a chunk invested to pay for discretionary spending.
Annuity appeal: If Rachel Reeves drags pension pots into the inheritance tax net in the Budget, then buying annuities may look more attractive
How I might play the retirement income game
The choices are numerous and can be daunting. The help of a financial adviser is crucial.
One of the common pitfalls is being drawn to a headline rate, evidenced in the FCA’s data.
It showed 80 per cent of annuity sales were level policies.
Buyers were opting for higher income today but leaving themselves vulnerable to future inflation, something an adviser might warn against.
I, for one, expect to keep most of my pension invested. I’ll aim to take a sustainable rate of income, hopefully no more than 4 per cent, and will consider an inflation-linked annuity for later in retirement.
Such a plan looks very different to my friend’s simple final-salary retirement but I will have at least created my own degree of final salary-style security.
