If you have a defined benefit pension you can skip the rest of this. You don't have to pay cash for your pension. But those on defined contributions (aka a pot of pensions savings) do. A 60year old women now needs to reach for Factor30 before heading to that retirement beach. Factor30 means she will have to multiply her desired pension (aka annuity) by thirty to get the cost.
£10 000 RPI linked pension at 60? That will cost you £300 000 madam.
Men have it easier (because they don't live as long), but a return of 3.35% for men aged 60 v 3.2% for women is nothing to write home about.
What to do? Should she hand over her £300 000 now? The choice is even more varied because the new government says you won't have to buy an annuity by 75 (actually you didn't have to before, but the alternative was so unattractive few people chose it).
First off our mythical 60year old pensioner - lets call her Alice - can increase her pension by 75%. All she has to do is forget index linking and go for a flat rate. The return jumps from 3.2% to 5.55%. For handing over her £300 000 she now she will have a fixed £1400 a month for life.
She could wait another five years - the current RPI-matching rate for 65year olds is 3.75%. Or she could continue to invest her pension pot and drawdown an income from it.
In an earlier blog we came up with a rule of thumb for drawing down from your savings: 4% a year (of that years total), rising to 5% in you sixties and 6% in your seventies. It meant your annual income would jump around as share prices went up and down, but there are ways of smoothing it.
So lets look at the various returns Alice could get on her money from annuities and/or drawdown.
Return rate 3.2% 4.7% 5.5% 5.0% from drawdown
Growth rate RPI 3% 0%/fixed ?/income could drop
income* £800 £930 £1400 £1250
*(monthly from £300,000)
I have thrown in an additional option of 3% growth. This may be better value than pure RPI, because the insurance companies at least have the certainty of knowing what their future payments are. Companies don't like uncertainty, and it's the consumer who ends up having to pay a hefty premium if they want the absolute certainty of RPI indexing.
What should Alice do? There is no single right answer here. Let's assume she needs £800/month immediately, and she has a pension pot of £300 000.
She could get £800/month by paying out all her £300 000 pension savings for RPI protection, or by paying out £175 000 to get a flat rate.
Alice makes her mind up: half annuity, half drawdown. She pays out around £80,000 for a flat rate annuity that gives her £400/month, and she draws down £400/month from her remaining savings (£220 000). Thats a drawdown rate of 2.2%.
Under this plan her monthly income will decline as inflation kicks in. But she still has her £220 000 fund to draw money from . How she should invest that £220 000 is another question.
note: go to calculators section at
http://www.moneymadeclear.org.uk/hubs/home_pensions.html
to check out annuity prices. Its not a complete list but it is a useful indicator. The rates quoted above are for a 'vanilla' pensioner: non smoker with no kids/spouses benefits, and no benefits/payback if you die the next day.
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