Another nifty way to boost your pension
Taking some extra risk can boost the size of your pension
Last month I wrote about four things you could do to boost your pension income in retirement. Today I’m going to add a fifth suggestion to the list. Unfortunately, it involves taking some extra risk, but it’s worth considering.
Before I go any further I should say that this article is only relevant for people who are building a pension pot via a defined contribution pension scheme. In other words, you and/or your employer are making regular contributions into a pension pot. Or you’ve built up a pension pot in the past.
If you’re a member of one of these schemes, you’ll need to convert your pension pot into an income when you come to retire. The most common way to do this is buy an annuity from an insurance company. Once you’ve bought your annuity, you’ll receive a guaranteed income from the provider until you die.
Related blog post
Annuities are great products in some respects, but they also have some flaws. The biggest is that many retirees in recent years have been very disappointed by the size of their pension payout. At the moment, a 65-year old man with a £100,000 pot will only get around £6,000 a year if he buys a conventional ‘plain vanilla’ annuity. That payout will be fixed until the man dies and won’t rise in line with inflation.
Take some risk
So what can you do? Well, one approach is to buy an annuity that isn’t fixed and is backed by investments in bonds or the stock markets. These are known as investment-backed annuities. If the investments perform well during your retirement, your income will rise. The danger is that your income may fall if things go badly.
Let’s take a look at the various types of investment-backed annuity:
Your pension pot is effectively invested in a with-profits fund that will then pay out an income for you. The with-profits fund will probably be invested in a mixture of shares and bonds and should, in theory, deliver a ‘smoothed’ return. In other words, you shouldn’t see the big rises and falls that can accompany a direct investment in the stock market.
If you've left your pension planning to the eleventh hour, find out how to catch up quick.
At first glance, the smoothed returns look attractive, but in reality, with-profits funds have had numerous problems, not least that they’ve often failed to deliver that fabled smoothed return. Steer clear.
With a unit-linked annuity, your pension pot is invested in some conventional investment funds such as unit trusts. If these funds perform well, your pension income will rise. If the funds perform badly, you’ll lose out.
Unit-linked annuities make sense for some people, especially if you have other sources of retirement income such as non-pension investments. That said, there aren’t that many providers of unit-linked annuities so you may struggle to find a really competitive product.
What’s more, if your pension pot is relatively large - £100,000 or more – you may be better off going for income drawdown. As with unit-linked annuities, drawdown will allow you to stay invested in the stock market and enable you to receive a higher income if your investments perform well.
Flexible or third way annuity
This is where things get really interesting….
A relative newcomer to the world of annuities is the flexible annuity. These annuities are invested in funds and can give you some exposure to stock market growth. But the risk is reduced because there is normally a guaranteed minimum income. In other words, your pension income can fall, but only so far.
You also get some control over where your money is invested and the charges on at least some of these products are pretty transparent – in particular, the MGM Advantage Flexible Income Annuity scores well on this point.
Transparency is clearly a good thing, but transparent or not, charges still have to be paid. Typically you’ll be paying between 0.75% and 1.5% a year. What’s more, there is also a lack of transparency on bonuses that are paid to retirees when some members of the scheme die relatively early in their retirement.
What to do?
As ever with pensions, I can’t give any firm advice that will apply for everyone. All I can say is that I was retiring today, I’d focus on either conventional level annuities or flexible annuities.
I like conventional level annuities because I know that I’ve got a guaranteed income for as long as I live. I like flexible annuities because they offer the possibility of growth at a relatively low cost and a guaranteed minimum income.
It’s hard to choose between the two so I might decide to split my pension pot in half. I’d use one half for a conventional level annuity and use the rest to buy a flexible product.