Retirement income using phased retirement strategies
David Trenner, technical director, Intelligent Pensions looks at how phased strategies may be used to generate an income stream at different stages of retirement
Phased retirement has been around since the old S226 Retirement Annuities were sold with 10 segments, each maturing in successive years, and aimed at professionals who were expected to wind down their working hours between 60 and 70. However it became more widely popular in the early 1990’s when providers started offering policies with as many as 1,000 segments, each of which could be vested separately.
A client with £100,000 in his pension fund who required net income of £6,000 in the first year of retirement could vest 200 segments, and take his income as £5,000 tax-free cash and an annuity income of £1,250 gross, £1,000 net. (Note: I have used 20% tax and current annuity rates for simplicity, both were different 25 years ago.)
Since 1995, when drawdown was introduced it has been possible to use funds to go into annuity or drawdown or a combination of the two.
Phased retirement income strategies are now essentially an advice process that enables a pension fund to be crystallised in stages, with income secured over a period of years. The process is predominantly used with income drawdown (now known as flexi access drawdown or FAD) but can also be used with annuities, uncrystallised funds pension lump sums (UFPLS) or any combination of the three.
While the size of a pension fund is not always a deciding factor on the choice of retirement income strategy, the cost of advice will usually mean that phased strategies are most appropriate for clients with larger pension funds, indeed the FCA used to use a figure of £100k to differentiate smaller and larger pension funds.
However, segmenting your service by value can be dangerous and it is essential that your advice process can identify phasing opportunities for any given pension value, particularly with so many now looking to take advantage of the new pension freedoms. Someone with a defined benefit pension of, say, £25,000 p.a. can use a whole different strategy for his £60,000 personal pension than someone who only has the £60,000 pot.
Phased strategies are essentially a gradual crystallisation of a retirement portfolio. Clients will often be advised to phase into drawdown before phasing out into annuities. Where tax-free cash is not required as a one-off lump sum, a phased strategy should certainly be considered and will likely be the standard for advice.
As a rule, most people take all their tax free cash when there is no need to. It might be argued that some salesmen who could earn large amounts by selling with profits bonds with their tax-deferred (not tax-free!) instalments have conditioned people to believe it is always the best thing to do. There is also a misconception that taking tax free cash is a ‘one bite of the cherry’ opportunity, whereas people can obviously take instalments of tax free cash at any time during their retirement including after age 75. There can be very good reasons for taking all the tax-free cash but unless the client can explain why advisers must challenge clients on whether to draw the tax free cash and consider the benefits and opportunities of not doing so.
Phased strategies, taking the tax free cash in instalments, ensures that less of the total ‘income’ is taxable and creates a highly tax efficient income stream in the early years of retirement. It also allows income to be varied to meet changing needs, such as part time working or state pension commencing. Significantly, this phased approach ensures that as much of the fund as possible remains and is payable tax free on death (before age 75) to the benefit of the beneficiaries.
Let us look at a possible phased strategy example:
Consider a retired teacher with £15,000 p.a. from the Teachers’ Pension Scheme, £5,500 p.a. of state pension and a £100,000 AVC fund. They have a mortgage of approximately £25,000 that they wish to repay in full and have stated that they would like to pass on as much of their pension fund as possible to their nieces and nephews.
A simple option might be to take maximum tax-free cash from the AVC of £25,000. Before the 2015 changes this would crystallise the full £100,000 fund and would have meant on their death, before age 75, the beneficiaries would have been subject to tax at the penal rate of 55%. Now there would be no tax on death before age 75, and the tax on death after 75 would reduce to the beneficiary’s marginal rate.
However, once tax free cash is taken all withdrawals become subject to income tax. So, a better option would be to take £30,000 out of the pension to provide tax free cash of £7,500 plus the balance of £22,500 taxed at 20%, giving the required £25,000 but also leaving £70,000 in the fund to provide for future changes in circumstance or tax free benefits on death before age 75, whilst keeping income within the 20% tax band.
As explained above, phased annuitisation was the original phased retirement strategy and started with retirement annuity plans for professionals. They typically had 10 segments allowing an annuity to be purchased each year as the working hours were reduced. This works in much the same way as phased drawdown but income is secured through the purchase of an annuity. For those who do not want the ongoing risks of drawdown, the concept of taking some tax free cash and buying an annuity every year could be particularly attractive. Each annuity can include different features such as a spouse’s pension, inflation protection, guarantees or value protection.
It is likely that since the introduction of drawdown some people who could have benefited from phased annuitisation have gone into phased drawdown or into full annuities.
We often recommend a phased annuitisation strategy for clients when looking to exit drawdown, typically in their 70’s. The key to phased exit strategies is to take advantage of ‘mortality cross subsidy’ while retaining some flexibility over the phasing period. As mortality subsidy is available via traditional annuities and some asset-backed annuities, it is possible to tailor an exit strategy to a client’s objectives and attitude to investment risk – this may involve a combination of traditional and asset-backed annuities.
Drawdown, by its very nature, becomes progressively less suitable as clients get older as a direct consequence of the ever increasing mortality subsidy available from annuities. From ages 70 to 80, the impact of mortality subsidy rises rapidly and by age 80, the critical yield for drawdown to keep pace with mortality subsidy becomes unrealistic. Providing drawdown investors with advice regarding the ongoing suitability of drawdown has been a regulatory requirement for some years. With the change to drawdown rules, staying in drawdown for too long is a very real risk to both clients and their advisers and is likely to become an increasing area of regulatory focus. For the majority, it is not whether but when to buy an annuity to mitigate the risks of living too long.
People’s lives do not stop when they retire, and their personal circumstances do not stop changing. Many lose a partner or divorce, while others remarry. Some do consultancy work or start part-time work. Others suddenly need cash for unexpected reasons, or come into funds that they did not expect to receive. Ongoing advice in retirement is therefore essential to take advantage of planning opportunities and check for ongoing suitability of the retirement strategy.
Phasing strategies should be the norm, not the exception. Advisers need to challenge clients about taking all their tax free cash and be ready to take action where a client is in danger of staying in drawdown too long – phased strategies in both cases might just represent best advice.
More options plus more flexibility adds up to more need for specialist advice from retirement income specialists.
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