Developed for financial adviser's use

Don't jump to the wrong decision

The new pension freedoms introduced in the March 2014 Budget give you far more choice as to when and how you access your pension savings, however with more choice comes the need for you to potentially make more decisions. Some retirement decisions can't be changed and could last a lifetime, so it's important that you understand all the options available before making any commitments. Retirement Hopscotch helps your financial adviser to outline the things we think you should watch out for, the range of options you have and the risks you need to consider. If you haven't got a financial adviser but are thinking about your retirement options, we recommend that you seek professional advice.

New Sequencing Risk feature: an interactive tool that shows the combined impact of investment volatility and income withdrawals
New Sequencing Risk feature: an interactive tool that shows the combined impact of investment volatility and income withdrawals

 
Financial advisers - go to lv.com/takeheart for more Budget guidance or speak to our Retirement Income Specialists on the LV= Retirement Desk 08000 850 250
 
Steps to think about...
Before accessing money from your pension fund, there are some important things for you to consider. Steps 1 to 4 act as prompts to help discuss relevant topics with your financial adviser. Step 5 will aid consideration of the risks involved with the different retirement income options you have, to help you and your adviser find the solution that best meets your needs.
1) Access
Start here
2) Tax implications
Skip to step 2
3) Your choice
Skip to step 3
4) Pass it on
Skip to step 4
5) Retirement Hopscotch
- the risks
Skip to step 5

RPI-Linked Annuity

With an RPI annuity, income goes up or down in line with the yearly change to the Retail Prices Index, which is a common measure of inflation.

The only risk in the Hopscotch process that applies to this option is changing circumstances, as it’s a lifetime annuity which can’t be changed once it’s been set up.

RPI-Linked annuities is the only option in Hopscotch that offers complete protection against inflation, although the income generated in the early years is very low compared to the other options.

 

Level Annuity

Level annuities pay out the same income, year after year, throughout your life. The income is fixed and guaranteed never to fall.

The two main risks that apply to level annuities are inflation and changing circumstances. Although the income is guaranteed for life, the spending power will be eroded over time as it won’t keep pace with inflation. Level annuities can’t usually be changed once in payment.

 

Investment-Linked Annuity

This is another type of lifetime annuity but income goes up or down depending on how the underlying investments perform.

They provide some protection against inflation if the investments selected provide a higher return than the underlying inflation rate.

They do carry investment risk, although investment-linked annuities come with a strong minimum income guarantee that can rise each year. As with all lifetime annuities, the changing circumstances risk applies to investment-linked annuities.

 

Fixed Term Annuity

Fixed Term Annuities allow you choose a fixed or increasing income for an agreed period of time, keeping your future options open.

As they’re not a lifetime annuity, fixed term annuities counter the ‘changing circumstances’ risk because the income structure can be changed at the end of the agreed period.There’s also an option to transfer out of the plan early.

However, annuity rate risk applies as nobody can guarantee future annuity rates - they can go down as well as up. There’s also an exposure to inflation risk because income is fixed over the period and some investment risk as investment returns are limited to the guaranteed future value.

 

Managed Drawdown

With Managed Drawdown, you can choose how much income you take each year within Government Actuary’s Department (GAD) limits by typically investing in investment funds.

Drawdown options allow a great deal of flexibility where you can take money directly from the pension fund itself. For managed drawdown, the income taken is carefully considered.

Drawdown options raise significant risks, apart from changing circumstance risk, because at any time the way income is being taken can be changed and a more secure option selected – so long as there is still money left in the pot.

The impact of investment risk can be reduced byselecting low risk funds; whilst some funds provide capital guarantees.Life expectancyrisk is exposed if you live a long life and withdraw more income then the fund can generate.

Although annuity rate risk is applies to drawdown products, it’s common for people taking drawdown to not want to buy into an annuity at any stage. However annuity rates, like stock markets do also go down as well as up.

Inflation risk is minimised by maintaining some investment in the fund with an expectation that it will grow at least in line with inflation.

 

Full/Partial Drawdown

These types of drawdown allow you to take more control of your pension fund.

A far more open approach is being taken than with managed drawdown, with the main objective being how to take money out of the pension whilst paying as little income tax as possible.

The risks for all types of Drawdown are the same. Inflation risk is hedged by maintaining some investment in the fund, and longevity risk is exposed if the person does live a long life.

Annuity rate risk also applies to those considering buying an annuity at some stage during retirement. Finally, investment risk is managed by choosing the right funds and spreading the risk across a range of assets.

 

Blended/Phased

This is a blend of all of the options we’ve looked at in Hopscotch – or the phasing of benefits, which means taking just part of your pension fund each time and creating your income stream from each part.

You can use some of your pension fund to secure a lifetime income, some to secure an income for say just 5 years and the remaining fund available to take withdrawals from as and when you require.

This option can be very tax efficient and also offer you some good underlying guaranteed income, with the flexibility of an additional pot to hold back for later life.

We’ve highlighted all of the risks in amber as the risks that apply depend on the options you choose.

 

Inflation

The Government publish inflation figures every month to measure how much prices are going up (or down). CPI (Consumer Prices Index) measures the changes in price of a basket of goods a ‘typical’ consumer buys. The contents of this basket are changed regularly to reflect changes in consumer demand.

Let’s look at the effect inflation has on a notional loaf of bread over a period of time. If we assume that you buy a loaf of bread which has 10 slices and inflation is 2% a year (which is the government target). The picture below shows how many slices you will be able to buy if your income stays the same during 20 years of your retirement.

As you can see, inflation can have a dramatic effect if your income remains the same throughout your retirement. The real value of a level income over 15 years will be halved if inflation runs at 5%. If inflation is higher (which it has been over the last 20 years) then the cost of goods and services will increase even more during your retirement. Older households experience higher rates of inflation because they spend much more of their budget on necessities such as food and fuel than other households. Thankfully the state pension rises at least by inflation each year and if you have a final salary pension, these usually rise each year.

A guaranteed income for life escalating with inflation provides protection against inflation risk.

Life expectancy

The risk you’ll be exposed to depends on whether you unfortunately die too soon or live a very long retirement.

Dying too soon

If you’re less healthy than average, there’s a risk that you’ll die too soon. Depending on the options you choose, you may not be able to pass on the rest of your fund to your spouse, or nominated beneficiaries.

Living too long

If you’re fit and healthy, you may live for a very long time. This may not seem at first glance to be a risk. However, if you haven’t secured an income for life then your funds may run out if you haven’t enjoyed favourable investment returns while withdrawing income.

Fixed term guaranteed income and flexi-access drawdown provide protection against dying too soon. You can also choose long guarantee periods on guaranteed income for life products to provide some protection.

All forms of guaranteed income for life provide protection against the risk of living too long.

Changing circumstances

With people living longer in retirement, you need to give serious consideration to potential changes in your circumstances before committing to a solution for your income needs.

 

 

 

For example, your health may change, you may be single and meet a new partner, or you may lose a partner. With a significant increase in life expectancy, people’s circumstances are more likely to change and not all retirement products will accommodate these changes.

 

 

Another consideration is that the rules surrounding what you're allowed to do with your pension fund may change as new governments introduce new legislation. Pensions rules have changed significantly in the last 10 years and this pace of change may continue. It's very difficult to predict what pension changes may be introduced in the future. Some retirement options provide the flexibility to keep your options open to enjoy any future changes.

Flexi-access drawdown provides protection against change of circumstances risk.

Annuity rate risk

A change in annuity rates has different impacts on retirement income, depending on the product chosen and when it's taken out.

An annuity is one way of providing an income in retirement. You transfer the value of your pension plan to an insurance company and in return they pay you a guaranteed income for the rest of your life. You can’t usually change any of the options. The amount of income you get will depend on how long the insurance company thinks you'll live which is influenced by your age, health and where you live. It also depends on the investment return the insurance company estimates they'll get from your money, which depends on long term interest rates.

If you choose another option in retirement and later choose a guaranteed income provided by an annuity there's a risk that the annuity rates could have fallen further. Annuity rates are currently low compared to historical levels. This has been caused by historic all time low interest rates and improving life expectancy.

Once you’ve secured a guaranteed income for life, annuity rate risk will no longer apply. For Retirement Hopscotch, this means that fixed term guaranteed income, drawdown and the blended solution are all open to annuity rate risk.

Investment risk

The chart shows the ups and downs of the UK Equity market since 1985

 

Some options aren’t guaranteed and therefore you'll be subject to the return which the underlying investments in your fund achieve.

Investments can go up or down. If you're taking an income from a non guaranteed fund and the investments fall in value then the level of income may be unsustainable and you may run out of funds. An important element of investment risk which is specific to people in retirement is caused by a combination of investment volatility and the sequence of investment returns. When you take withdrawals from your funds the sequence of the returns is vitally important.

If you experience strong growth in the early years and then experience losses in later years, your fund may still be able to provide a sustainable income.

If however you experience losses in the early years, followed by growth then your fund may still have declined in value and may not be able to provide the level of income you require for the rest of your life.

The timing of returns is a very important risk affecting the long term value of your fund.

We've designed an interactive tool to help illustrate the impact that the sequence of returns can have on your pension fund when taking an income during retirement.

In Retirement Hopscotch, investment risk mainly applies to the UFPLS, drawdown and blended solution options.

Lifetime vs Fixed Term Annuity Calculator

This unique tool from LV= helps clients make more informed decisions when choosing between a Lifetime and Fixed Term Annuity. Enter client-specific quotations for a Lifetime and a Fixed Term Annuity to compare both options against different potential scenarios.

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Inflation protected guaranteed income for life

With an RPI annuity, income goes up or down in line with the yearly change to the Retail Prices Index, which is a common measure of inflation.

This might be suitable if you’re very cautious, probably very healthy and want to reduce the risk of inflation to a minimum. It would provide an income for life; without waiting to see if annuity rates rise – or indeed fall again – and there'd be no investment risk.

It provides a very low risk solution. However an RPI annuity can’t be changed once it’s been set up (changing circumstances risk) and sadly if you were to die earlier than expected you may find yourself not getting all of your money back.

The other challenge of this type of annuity can be that the income generated in the early years is very low. This is because the income is designed to increase each year.

Level guaranteed income for life

Level annuities pay out the same income, year after year, throughout your life. The income is fixed and guaranteed never to fall.

This could be a good solution if you’d like an income secured for the rest of your life, and perhaps for the rest of your partner’s life too. A level annuity will pay a higher level of income then an RPI annuity initially but it will never increase. The changing circumstances risk is the same as for an RPI annuity but it’s important to understand that the level annuity carries the risk of inflation, because although the income will be guaranteed, it will always be the same and the spending power of that income will gradually reduce each year.

From April 2015, pensions legislation has changed to allow insurance companies to change the amount of income paid over time. So for example, an annuity can pay more income in the first 10 years and then reduce to an agreed level from year 11. Your adviser will be able to provide more details as and when new annuity products are available.

Investment linked income for life

This is a lifetime annuity where income goes up or down depending on how the underlying investments perform.

An investment-linked annuity will typically provide a higher starting income than a RPI annuity but the starting level income depends on the assumed investment return chosen at the outset. They provide some protection against inflation if the investments selected provide a higher return than the underlying inflation rate.

Although investment-linked annuities come with a strong minimum income guarantee that can rise each year, it does not remove inflation risk completely, and it also carries some investment risk. Understanding the numbers behind the annuity options and comparing the guarantees is therefore an important discussion between the adviser and client.

As with all lifetime annuities, the changing circumstances risk applies to investment-linked annuities.

Fixed term guaranteed income

Fixed Term Annuities allow you choose a fixed or increasing income for an agreed period of time, keeping your future options open.

If locking into a lifetime income is not what you’d want to do at this time, you can consider a fixed term annuity. It provides a secure and guaranteed income for an agreed period of time, anything between 3 years and 25 years, and provides a pre-determined guaranteed value at the end of the term, which you can decide to use as you then wish. There’s also an option to transfer out of the plan early.

Fixed term annuities counter the ‘changing circumstances’ risk because the income structure can be changed at the end of the agreed period, however there’s now an exposure to what is known as annuity rate risk, because nobody can guarantee future annuity rates - they can go down as well as up. There’s also an exposure to inflation risk because income is fixed over the period and investment returns are limited to the guaranteed future value.

Uncrystallised Fund Pension Lump Sum

As part of the new legislation which came into effect in April 2015, there’s a new option to access your pension funds called uncrystallised funds pension lump sum (UFPLS).

An UFPLS is a direct withdrawal from your pension which is comprised of 25% of tax free cash and the remaining 75% will be taxed depending on the tax code your pension company holds for you. You therefore need to be careful of emergency tax codes if you haven’t supplied a P45 for the current tax year to your pension company.

This option allows you to keep your pension invested with your current pension provider and take direct withdrawals of tax free and taxed income. UFPLS mitigates change of circumstances risk and the risk of dying too soon. However, you’ll have some exposure to all the other risks.

Drawdown

Drawdown provides a high degree of flexibility of how much income you take and when you decide to take the income.

You choose where to invest your pension fund, and you can withdraw as little or as much income as you wish at a time which is convenient for you. You can withdraw your tax free cash in one instalment or over time, which may be important if you decide to continue contributing to a pension.

Drawdown plans are also attractive if you wish to pass your pensions funds to dependants and beneficiaries if you unfortunately die. You can nominate any person or body (including charities) to inherit your funds. If you’re under age 75 when you die, your nominated beneficiaries receive your pension funds tax free. On or after age 75, any withdrawals or lump sums taken will be taxed at their marginal rate. Your beneficiaries then have complete freedom to nominate successor beneficiaries who’ll inherit your pension funds should your nominated beneficiaries die. This is particularly useful if you want to pass your pension wealth to your children and grandchildren.

The high degree of flexibility within drawdown mitigates the change of circumstances risk. However, you’re exposed to annuity rate risk, investment risk and living too long.

Blended solution

As you’ve seen in the previous pages, there is no single product solution which mitigates all the retirement risks.

As part of the Retirement Hopscotch process, your adviser will provide a report, including a questionnaire for you to complete to help them determine the risks you’re mainly concerned about during your retirement.

Your adviser can then decide on which product or combination of products will provide the certainty of income and flexibility you require and mitigate the risks which are important to you. You'll therefore receive a solution tailored to your needs.

LV= Retirement Pathfinder

A unique online tool that can bring to life any blend of retirement products you want to consider. Simply visit the tool, enter a few client details and you can easily compare and contrast any single/and/or multi-product combinations in pound and pence scenarios throughout every year of their retirement, on a like for like basis.

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