With big changes in the rules on pensions, wealth advisors are balancing flexibility and security

Much has changed in retirement planning in recent years – and, arguably, even more so over the last year. Why? To take the most recent events first, back in 2020, if you had government bonds as part of your portfolio, they were paying out less than 0.5 per cent annually. Today, the average annual yield for UK 10-year bonds is around 4.5 per cent.

Why does this matter? One of the basic tenets guiding wealth advisors as they help clients plan for retirement is that it makes sense to ‘derisk’ the client’s pension pot as they near retirement.

This is because the client is obviously running out of time to recoup any losses that they make while being invested in equities, should there be a sharp market move downwards. 

So, logically they would shift the client’s portfolio to near zero-risk investments such as government bonds. A whole swathe of so-called lifestyle funds developed and became popular based on this principle of rebalancing a client’s retirement portfolio from risky to non- or ultra-low-risk assets. 

However, the problem with this approach, as Derek Fish, the managing director of Lomond Wealth explains, is that these funds gave up all chances of growing the value of the portfolio and generated near zero income. 

If you were selling out of say, dividend stocks with a good history of paying between 2 and 4 per cent, and finishing up with government bonds paying 0.5 per cent or less, that was not exactly a winning idea. Yes you were ‘derisking’ your pension pot, but you were losing hand over fist. That was not what ‘de-risking’ was supposed to mean.  

However, perhaps the biggest change in retirement planning wasn’t so much based on interest rate movements as on a rule change initiated by government. On 22 June 2010, the government of the day announced in an emergency budget that as from the following April, it would no longer be mandating annuity purchases for people with retirement pots. 

Instead, wealth advisors shifted to focus on strategies such as achieving a balance between investing in income-generating assets such as dividend-paying stocks, and growth assets. The latter term covers a broad range of options: everything from investing in emerging markets to active managers picking high-growth stocks. 

Then there is the problem of what to do with your pension pot when it is time to retire. Before 2010, this was not much of a decision. If you had been building a retirement pot through an approved provider, the growth in your pot was tax-free. However, the law stated that you had to buy an annuity before you turned 75. There was no option. 

In 2010 the government changed the rules. Starting from the April 2011 tax year, purchasing an annuity was no longer mandated. It became optional.

As Fish notes, wealth managers and their clients moved away from annuities and started to opt instead for flexi-drawdown. As the name suggests, this approach looked to supplement whatever monthly income your retirement portfolio was generating by drawing down, ie selling, modest chunks of your assets to supplement that income. 

The risk the client runs with flexi-drawdown, of course, is that you may well draw down your whole pension pot and run out of money before you run out of life. 

On the plus side, as Fish notes, with flexi-drawdown, you are not ceasing to invest on the day you retire. Your pension pot keeps on working and generating growth and income long past the date of your retirement. 

The head-scratching part of this is that if you had a large percentage of your retirement pot invested in interest-paying dividend stocks there was an obvious downside to selling any of those stocks. Yes, you get a chunk of money immediately to supplement your income, but it is at the cost of forfeiting who knows how many years of future income from the sold stocks. 

It should be clear that this is an area in which people can really benefit from getting sound advice on a regular basis.

As if this calculation was not complicated enough, the current steep rise in bank interest rates means that annuities have suddenly started to seem very attractive again. 

Three years ago, there was virtually no incentive to voluntarily opt to put some or all your retirement pot into an annuity. In March 2020, for example, the UK experienced the lowest bank rate in the last 100 years. Rates dropped to just 0.10 per cent. They didn’t move back up until December 2021. 

After that, of course, Russia invaded Ukraine, gas prices jumped and interest rates went skywards as inflation zoomed up to 10 per cent. As a result, today you can buy an annuity that would pay you four per cent or somewhat better, annually, for the rest of your life. 

Emma Wall, head of investment analysis and research at the financial services company Hargreaves Lansdown, points out that people need to be aware that this favourable window for buying annuities could well be temporary. 

The current high-interest rate regime in the UK could fall away if the geopolitical situation improves or other as yet unforeseeable factors come into play.

“Our house view is that interest rates are very likely to stay stable at current levels for perhaps the next nine months or more. However, people should be aware that the current very reasonable returns that an annuity can produce may well be a short-term phenomenon,” she says.

Wall says that she and her colleagues are currently favouring the ‘bucket’ approach. This is where you opt to put enough of your retirement pot into an annuity so that the payout each year is enough to cover all your major monthly bills. That buys you peace of mind. But you leave the rest of the money invested in a diversified portfolio and in cash. 

In this way, she points out, you could continue to have the annuity supplemented by, say, twice yearly dividends, but you have the freedom to cash in chunks of your retirement pot on an ‘as needed’ basis. 

This gets around the major drawback of an annuity, which is that the money you put into buying the annuity is gone forever, and the annuity dies with you. Or, with some annuities, it continues but dies with your spouse. In either event, there is no access to the original sum that you put into the annuity. 

“It must be recognised that now is a great time for anyone who is retiring in the next few months to consider investing in whole, or in part, in an annuity that pays four percent or somewhat better. That kind of return has not been available for years and it might not be around for long. This is definitely an area where people can benefit hugely from seeking professional advice from qualified wealth managers,” says Wall.