The safe way to juggle your pension priorities
In the fourth of a series, James Patterson shows how to take income from personal contracts
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Your support makes all the difference.AS earlier articles in this series have explained, investors wanting to take the benefits from their personal pensions now have two choices. They can either buy an annuity or they can take an annual income (plus a lump sum) from their funds, deferring the purchase of an annuity.
If an investor does decide to take income from the fund then he or she has three decisions:
q How much income to take out each year within the Government's maximum and minimum limits;
q How to invest the remaining funds in the plan; and
q When to cease taking income and buy an annuity.
The potential danger inherent in using the new income withdrawal facility is that the fund within the contract will become depleted through a combination of too much income being taken out and poor investment performance of the remaining funds.
If interest rates, and hence annuity rates, are low, then the income secured from the depleted fund will also be low. The investor using the income withdrawal facility cannot make any further contributions to the personal pension contract from which income is being taken. So any shortfall in investment performance cannot be repaired.
It is vital that the investor is prudent with the amount of income taken out each year. It is also vital to get the investment strategy right and to maintain that strategy until the annuity is eventually bought.
When considering how much to take out, the investor should be wary of withdrawing the maximum permissible amount of cash, simply because it is available. The more cash that is taken out, the greater the shortfall that the remaining fund has to make up. The investor should assess his or her income requirements for the coming months and decide how much of this income needs to come from the personal pension.
Next comes the decision on how to invest the remaining funds. As always, the investor will face the usual growth-versus-volatility dilemma when choosing an appropriate investment strategy. The remaining fund should grow by at least the amount taken out as income, so that the overall value is not depleted. That implies the investment should be in equities.
However, equities are the most volatile class of investment. The fund would be rapidly depleted if part of the holding in equities had to be cashed in during an equity bear market. And investors are forced to cash in at least the minimum income amount, whatever the market conditions.
One solution to this dilemma is the classic compromise between equities and cash - a fund invested partly in cash from which to pay the income, with the rest in equity funds.
When income payments have been taken, the cash balance should be restored by cashing in part of the equity holdings at an appropriate time when the equity market is buoyant. The investor has to decide how much of the fund to hold in cash, remembering that, overall, cash has a lower return than equities.
A review of past investment returns shows that equity bear markets rarely last more than 12 months. So a prudent cash holding would be around two or three years' income payments. But much depends on how much risk the investor is prepared to take.
This approach does mean that the investor has to constantly review and change the composition of the underlying funds on the personal pension contract. The investor cannot simply take the income and forget about everything else.
An alternative investment strategy is to invest some or all of the fund in with-profits funds, the unit-linked variety, where the value of the fund is guaranteed not to fall. Returns are lower than on equities but may be higher than a combination of equities and cash.
The dangers of taking maximum income from a personal pension contract are shown in the table (left), based on growth illustration requirements of the Personal Investment Authority.
Every three years, the income withdrawal limits are recalculated. If investment returns are dull and interest rates low in three years' time, then the new limits could be lower than the initial limits.
The impact of income withdrawals
Man aged 63. Fund value pounds 100,000.
pounds 25,000 taken as tax-free cash. The remainder - pounds 75,000 less charges - is used for income withdrawal.
Assumed investment growth of 6 per cent a year
Year Fund at start of year (pounds ) Max income taken in year
1 72,600 7,910
2 68,100 7,910 3 63,400 7,910 4 58,500 5,440*
*New maximum income limit at the first three-year review
Assumed investment growth of 9 per cent a year
Year Fund at start of year (pounds ) Max income taken in year
1 72,600 7,910 2 70,200 7,910 3 67,600 7,910 4 64,800 7,250*
*New maximum income limit at the first three-year review
Assumed investment growth of 12 per cent a year
Year Fund at start of year (pounds ) Max income taken in year
1 72,600 7,910 2 72,200 7,910 3 71,800 7,910 4 71,400 9,350*
*New maximum income limit at the first three-year review
Source: National Mutual Life.
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