The best plan I’ve seen yet for securing your retirement income is to create a minimum income floor. This entails investing your pensionable assets in the safest financial products that can cover your basic needs for the rest of your life.
Anything left over is tucked away into your emergency fund and a ‘risk portfolio’ that’s tapped when you want to pay for life’s little luxuries.
It’s the retirement equivalent of hitting the casino with your play money in your top pocket but keeping your bus money strapped to your leg.
Floor in the plan
So how do you go about constructing a minimum income floor?
Firstly, the point of a floor is that you can’t fall through it. In other words, if you need £12,000 a year then your floor should always stand you that amount until you pop your clogs.
Secondly, the floor must be protected against financial dry rot:
- Inflation – This money-eating fungus can halve the value of your cash in a little over 20 years at the inoffensive rate of 3%, or in three years at a galloping 20%. And £12,000 per year is no good when it only buys you £6,000 worth of retirement. This is why most retirees don’t have the luxury of staying in the safest asset class of all: cash.
- Bad market returns – A portfolio of equities and bonds is too risky for a minimum income floor. There’s no way to be sure that a gruesome bear market won’t chew up your wealth and leave you unable to sustain your lifestyle.
- Bankruptcy – Banks, insurance companies, annuity providers and fund managers can all go bust. Retirement income products may need to last 30 years or more, so as ever it’s important you don’t place every egg in one smash-able basket.
Planks for the memories
So which financial products can form the planks of your income floor?
William Bernstein, investment advisor and scourge of Wall St, has narrowed the options down to three in his riveting book, The Ages of the Investor
Option 1: Boost the portion of your floor covered by the State Pension
The State Pension is the best annuity around: an inflation-linked, government-backed income stream that will flow for the rest of your life. Money doesn’t get any safer than that.
You can boost your UK State Pension by deferring your claim. Every year of deferral increases your income by 10.4%. It can take a decade to recoup the cash forgone but it’s a good hedge against a long life.
Option 2: Build a ladder of index-linked government bonds
Again you’re inflation-proofed and putting your faith in virtually risk-free assets.
The key to not losing money on the deal is to buy individual index-linked bonds directly from the Government and hold them to maturity. As opposed to buying bonds in the secondary market or in bond funds.
As each bond matures it pays a portion of your income. All will be well provided you don’t live longer than the top rung of your ladder.
That whopping great snag aside – not to mention the miserable returns you currently get on index-linked gilts (also known as ‘linkers’) – this option is nowhere near as effective in the UK as it is in Bernstein’s America.
Here’s the problem: The fastest-maturing linker you can buy from the UK Government this year will pay you back in 2019. The next rungs on the ladder wouldn’t be reached until 2024 and then 2029. You’d receive income in five-year blocks that will be vulnerable to inflation until your next pay out day.
Option 3: Invest in a conventional, index-linked annuity
Inflation-protection? Check. Income guaranteed for the rest of your days? Check.
Risk-free? Nope. The annuity provider could go belly up, although there’s no modern precedent for this in the UK.
If the worst does happen then the Financial Services Compensation Scheme (FSCS) would cover you for 90% of the annuity. Ideally, you’d have a couple of annuities from different providers to prevent your income being totally disrupted by delays or even the complete malfunction of the FSCS scheme.
Nailing it
None of the options are perfect. The State Pension is too small, the linkers scant in supply and returns, and the annuity is only as good as the credit risk of an insurance company.
In my case, I’m currently helping a close relative secure her minimum income floor, and I think the best way to do that is by combining the State Pension with a conventional, index-linked annuity.
Here are the important numbers:
- £12,000 – my relative’s required minimum income floor (after tax).
- £10,000 – the tax-free personal allowance 2014-15.
- £12,500 – the gross income my strategy needs to deliver to account for tax.
- £3,500 – the amount of State Pension my relative receives.
- £9,000 – the income required from the index-linked annuity.
Happily my relative’s situation is relatively simple. There are no dependents to increase the cost of the annuity and niceties like leaving a legacy can be jettisoned in the face of nailing down her retirement income.
Yes, she has to cede control over the majority of her pension pot but I believe it’s worth it to ensure she’s as secure as possible from here on in.
Critically, there’s enough left over to form an emergency fund and to invest a small portion for future desires.
A level annuity would provide a much bigger income today and the greed demons kept whispering in my ear: “It’ll be fine, inflation will stay low, take the big bucks now.” I’ll explore how close a call this is in a future article.
But my job is to take as much risk off the table as possible, including the risk of the inflation genie escaping his bottle and going on the rampage.
That thought is enough to make me recommend the pure version of the minimum retirement income strategy. With the floor nailed down and inflation-proofed, it should endure through most of the disaster scenarios a retiree is liable to face.
Take it steady,
The Accumulator
I once saw an American blog that advocated that Americans consider buying an annuity in Swiss Francs.
That, I suspect, might make a decent protection against UK inflation. So, my question: is it practical to buy an annuity in SwFR, Norwegian or Swedish Krone (sp?), Singapore dollars, or whatever?
So i’m guessing that annuity to provide £175pw indexed to inflation probably costs c. £300k upfront from an insurance company?
@dearieme — I have no idea on the practicalities, but I’d be very cautious about currency risk in retirement. You are running down (generally) or at least spending the income on your assets to buy UK denominated goods and services. So you’d really need to make sure your needs are met in sterling terms — and a 30% currency swing could wreak havoc to those plans.
Of course it could also work in your favour, but it’s not a risk I’d want to take with my income floor.
Perhaps something to consider for a portion of the speculative post-retirement / above-the-floor portion, if one was keen, or particularly bearish on the UK pound?
I actually went and bought the Bernstein book after your last post – its an interesting read, if only to marvel at the generosity of the American social security system (not really what I was expecting from the land of low taxes and allegedly limited welfare safety net. Just why is the UK state pension so miserly I wonder?).
Couple of questions: do we know yet whether deferral of the new flat rate state pension will be possible, and on what terms? (and if we don’t get it till we’re 68 anyway, is deferral even a realistic option?)
Second, how does one buy gilts direct from the government when they are issued (and how do you find out the price and other important parameters), and does it really make much difference compared to buying on the open market?
Presumably also that given current negative real yields, you would need to invest more than your income requirments to make up for the shortfall. And tax would take a bite of the coupon (but perhaps no worse than the tax on an annuity income stream).
“do we know yet whether deferral of the new flat rate state pension will be possible”: as of a few months ago, the terms for deferral would be that the reward would have to be extra pension (i.e. no lump sum) and it would be at 5.2% p.a. instead of 10.4% p.a.
How about an income drawdown pension? More complicated than an annuity as it requires a degree of management but much more flexible and you could easily recreated an annuity using linked government bonds while not locking yourself into the current awful annuity rates.
TA,
This post just shows how generous public sector pensions are. I don’t want to hitch my retirement plans to the government defined state pensionable age, which will probably be 75+ by the time I get there.
Conventional index linked annuities spread across 4 providers is the way to go for my minimum income floor.
Reg, Jon
@vanguardfan
You can buy gilts from the DMO by post, but the admin is outsourced to Computershare (owned by Capita I think):
http://www.dmo.gov.uk/index.aspx?page=Gilts/Retail_Brokerage
http://www.dmo.gov.uk/index.aspx?page=Gilts/FAQ
Years ago I used to do this, nowadays I just use a platform
Delightfully old-fashioned isn’t it?
Checking latest annuity rates for 55 year old, £100K fund:
Level rate + 100% joint Life = £4,000
3% escalation + 50% Joint Life = £2,679
So you will need £447K to generate £12,000pa with 3% escalation.
Good news is that 15 year gilt yields increased from 2.17% to 2.46% last month, so we should see improved annuity rates in future as yields rise (gilt prices fall). I believe the annuity rates are determined by 15 year gilt yields.
This is a great source I use:
http://www.sharingpensions.co.uk/annuity_rates.htm
Reg, Jon
@ Jon
I’m very sceptical about annuities because I think the insurance companies are a poor credit risk for the return offered and Mrs Neverland shouldn’t have to live off just half my pension when I peg it
Equally if Mrs Neverland were to pop her clogs first and I get married again guess how much of my annuity the “generous” insurance company will give to my second wife after I die? Nothing, of course
I’m just going to self invest and manage my own fund in drawdown probably
But Neverland – Mrs Neverland could become the scourge of your annuity provider and be known as Foreverland, if she ever got past centenarianland…
Imagine the joy, a telegram from the Queen and getting one over an annuity provider!!!
Horse fly – Tick
Dragon fly – Tick
Pigs fly – Tick
Elephant fly – No
> Ideally, you’d have a couple of annuities from different providers to prevent your income being totally disrupted by delays or even the complete malfunction of the FSCS scheme.
If the FSCS scheme were to malfunction, this would, in all likelihood, have been caused by multiple providers going belly up. Splitting annuity arrangements between two providers offers limited protection against consequences of such a scenario.
On a more general note, I am skeptical about using cash to buy an annuity. This can certainly be part of the solution, but by using all the cash this way you are almost bound to get a poor deal. I reckon that one of the reasons annuity rates are so poor is that under the current rules a lot of people have to buy an annuity with most of the money accumulated in their pension scheme – so annuity providers have a captive market to exploit. Your elderly relative is not part of that captive market, so common sense suggests that a better deal is likely to be achievable for her (with similar guarantees).
> You can boost your UK State Pension by deferring your claim. Every year of deferral increases your income by 10.4%.
Assuming that a deferred pension remains inflation-linked during the period of deferal (does it?), you would need to defer your relative’s pension by 13 years to achieve the target income floor from the state pension alone: £3,500*1.104^13=£12,667 in today’s money. I suspect that it may be possible to make very reliable arrangements for the first 13 years with less cash than what you would need to buy an index-linked annuity paying £9,500 a year.
Following up on my previous comment, it turned out that a deferred state pension is not adjusted for inflation during the period of deferral (which I half-suspected – the deal looked too good to be true). Still, deferring for as long as inflation remains reasonable sounds like a sensible way forward. With inflation of up to 3% you would remain on track for achieving the target income floor from the state pension alone in 18 years or less – the £300K or so required to buy an index-linked annuity in your scenario would certainly see your relative through those 18 years comfortably. As soon as inflation surges, you can buy an annuity for the shortfall (with some money left over to play with) and start drawing the pension.
@oldthinker
Nice idea. However the late retirement increase for state pension (for those reaching SPA before 6th April 2016) is 10.4% pa simple not 10.4% compound so we are looking at 25 years rather than 13 before the late retirement increase brings the state pension up to the region of £12,500 pa. From the figures it looks like it would be difficult to fund this 25 year gap.
On a separate point I am assuming that there are no missing state pension qualifying years that could be purchased with class 3 voluntary contributions?
Of course if there is owner occupied property involved here then there are options to use that as a backstop to any investment strategy ‘if the money runs out’ through moving to a smaller property or using equity release etc at a later date (?)
“Following up on my previous comment, it turned out that a deferred state pension is not adjusted for inflation during the period of deferral .” This, I think, misrepresents how it works. Say you defer 5 years, then your annual extra pension = 5 x 10.4% = 52% of the annual pension that is otherwise payable at the moment you restart the state pension. Since that pension has been index-linked during the five year suspension, your reward effectively has been index-linked during those five years.
here’s the source
http://www.direct.gov.uk/prod_consum_dg/groups/dg_digitalassets/@dg/@en/@over50/documents/digitalasset/dg_200597.pdf
@dearieme
Yes you are right and I got it wrong for some reason when I quickly checked the same source earlier. This means that deferring is an excellent deal, even though the effective interest does not compound as pointed out by Snowman above – no wonder they are making this deal far less generous under the new rules.
So it may well be worth considering this option under the circumstances. Perhaps for not more than 10 years because the lack of compounding will start biting by then, but even after 5 years an annuity covering the shortfall will be much cheaper because the shortfall that has to be covered will be smaller by £1820/year (that is, by 20%) and the recipient 5 years older (a further 20% saving, looking at the current rates for escalating annuities). On this basis, it seems to make a lot of sense to defer the state pension and postpone purchasing an annuity.
Jon highlights one of the reasons my original goal of full retirement at 55 is impossible. Not just the fact that you won’t have accumulated a big enough pot (through both contributions and compounding over time) but annuity rates are diabolical for anyone starting drawing an annuity 10 years early – compared to the oft quoted norm of 65. Income Drawdown will be a useful alternative, perhaps switching to an annuity at 75 when you get a much better rate.
I don’t see deferring the state pension until I’m 77-87 to be a brilliant choice for obvious reasons. There is an increasing risk of it being pushed out to 70 anyway.
While annuity rates should improve, this will be tempered by increased life expectancy.
@Semi
We are planning to retire at 55 using income drawdown and our pension funds are on target to hit the target size with a bit of luck
I do think annuity rates will improve quite dramatically at some point before we retire, simply because interest rates are currently at a 300 year low
As interest rates go up, the fund investments will take a hit but it will be worth it for the better income return on retirement
I’ve never been attracted to annuities that escalate at a fixed rate. My inflation fear isn’t of (say) an approximately steady 3% p.a., it’s of a few years of a 1970s-like 20% p.a. or so. Therefore I’d want an RPI-linked annuity. Until we’re about 75, we’ll stick to drawdown.
@ Neverland – you’re right, circa £300K.
@ Vanguard fan – given that the pension age is being pushed out because we’re living longer, I think it is legit to defer even if you don’t receive the pension until 68. The State Pension is an excellent hedge against old age and many of us will keep on going into our 90s and 100s.
If I buy the gilts direct from gov then I’ll get my capital back, plus RPI, plus a smidge of interest as long as I hold to maturity. No need to invest more than income requirements. I’m overlooking the spectre of deflation here. I’ll get less than my capital back in those circumstances but then prices will drop too.
@ Mucgoo – the point of the minimum income floor is security. So yes, there are more flexible options with greater upside but they entail more risk. The idea of this strategy is to remove as much of that risk from the equation first and then use the money left for the fancy stuff.
@ Old Thinker – quite right, splitting your annuities does offer limited protection. Still better than not, eh?
My relative gets way below the maximum pension allowance for one reason and another. Mostly to do with making the mistake of being a woman and raising kids, as far as I can tell.
Again, I think you’re falling into the same trap as Mucgoo. The point of the strategy is to remove the uncertainty from the equation. She has enough now to secure her future, so given her level of expertise and interest in managing a portfolio, better to take that path than hope for limited, possibly negligible upside in the future.
@ Snowman – you’re right about the property option, though that would be a dark day in hell emotionally. Saving that one for when the emergency fund runs dry.
@ Dearime – thanks for making that point. I should have been clearer about that in the article. The figures I quote above are for an RPI-linked annuity. I would take a CPI-linked annuity if the RPI was too expensive. As part of the triple-lock the State Pension is linked to CPI.
Good comments all, as always. Thanks for the links too!
@The Accumulator,
Is your relative already retired and in receipt of the State Pension?
If not, then you could consider making up the shortfall in NI contributions. The terms used to be very generous.
Furthermore, any addition you can secure to the State Pension is subject to the “triple lock” for the time being anyway.
That’s an excellent idea, Grumpy. I’ll look into that.
@ Old thinker – I’d definitely wouldn’t recommend that anyone sinks all their assets into an annuity. You need a store of nuts to cope with the unexpected. Which is one reason why pension deferral may not be a great idea for my relative. Though it would increase her income in the long-term it would eat up a hell of a lot of the emergency fund. The loss of flexibility in this instance may not be worth it when the minimum income can be secured another way.
@The Accumulator,
NI voluntary contributions seem to allow you to make up as much as 12 years but the rules are very complex.
If you could boost your relative’s state pension to £5500 and defer by say 5 years, you’d have an income of thereafter of some £8000 (based on the current uplift of 10.4% simple interest) from the State Pension alone and so need a much smaller annuity. The cost of boosting the SP and deferring it for 5 years might be around £33000. But the annuity you now require only needs to generate £4500 instead of £9000 leaving you with a much bigger emergency fund or the option of securing a higher income via the annuity.
Looks like a lower risk option too with less dependency on annuities.
You obviously don’t need to defer both the State Pension and annuities but can mix and match as you see fit.
Impossible to get the solution perfect because you’d need to know how long your relative should expect to live. There are life expectancy prediction tools available on the internet but I wouldn’t bet on their accuracy!
We’ve paid missing NI contributions for “GOP’s Long-Suffering Partner” which is why I’m aware of that option. For myself, I’m going to have to decide whether, and for how long, to defer the State Pension. I’ll probably opt for a relatively conservative estimate for my life expectancy of say, 80 years, instead of the 87-93 years that on-line life expectancy prediction tools indicate.
@GOP
Making up lost years of NI contributions is indeed stupidly cheap (only it used to be even stupidly cheaper)
However, this is one of the reasons I don’t think that the “triple lock” will last the next parliament
Inflation protection for state pensions was removed by Margaret Thatcher in the 80s and only reinstated fairly recently, so its not a given
By 2015 the social security budget will be mostly spent on pensioners
In order to move to a budget surplus it will be unavoidable that public spending in areas previously ringfenced is no longer ringfenced, simply because they will become so much of the total budget
Less government spending + more pensioners = less government spending per pensioner
@Neverland,
I agree with your comments. If/when the proverbial really hits the fan, I expect a “Government of National Unity” (Lab/Tory coalition!) to enact a number of measures and am planning accordingly. I reckon that existing stocks and shares ISA savings will be left alone and retain their tax exemptions but I do expect additional contributions to be stopped at some point. Cash ISAs may survive but I wouldn’t count on it.
I assume also that income tax and NI will be merged in the future and that pensioners with an income in excess of a (greatly increased) personal allowance will have a much higher marginal tax rate.
So, where there are generous provisions in the tax/NI/pension/savings regimes, exploit them while you can, because, eventually perforce, the government of the day will notice and remove them. And a “Government of National Unity” won’t care about the size of the pensioners’ vote which will be the least of their worries.
Index-linked National Savings Certificates, MIRAS, generous earning-related unemployment benefits, practically unlimited tax relief on pension contributions have all gone so don’t assume anything will last forever.
“Expect the best, plan for the worst, and prepare to be surprised.”
Has there ever been an article on passive investing for income? I came across this one whilst looking for info for a relative who has annuities and other income but has a portfolio of investments that they want to produce an additional income from now rather than growth. Have you guys done an article on this? Not sure this is the best place to pose this question. Cheers.
@Geo — We haven’t really done that, as @TA doesn’t believe in it and thinks you should go for total return and sell capital units as required. (I understand the argument but don’t 100% agree). The comments on this article about investment trust income in retirement might have some ideas for you: http://monevator.com/investment-trusts-for-deaccumulating-income-investors/
@TI – Thanks so much. I’ve read the grey beard one and its a great thought to consider. Maybe you three could have a debate post about each of your ideas – hehe. Thanks so much for replying!
Check out Vanguard’s site. They have a UK Equity Income fund and an All-World High Dividend ETF – VHYL.
They also have a minimum volatility ETF.
Like The Investor says though, I prefer a fully diversified, total return approach.
Thanks TA!
Scrolling through I found though s article which is relevant to my position. I have worked for the NHS for the last 35 years and am taking slightly early retirement (58).A colleague told me last year that the NHS hadn’t been taking the correct amount of N. I. contributions every month and there may be a shortfall in qualifying years for the State pension, in my case at 67. When I looked into last year he was right, I am 1 year short approx £180 annual. Can I buy this missing year and how?. I did ring the dept but t G ey were not helpful as I was still employed. Sorry for the length.
David
Maybe the advice on this page helps?
https://www.gov.uk/voluntary-national-insurance-contributions
Just came across this article and wondered how much an index linked £9k pa annuity would cost now? Think I saw rates at near to 1% for a 55 year old male in good health. I haven’t looked, but suspect linkers would be a similar rate? The cost of the floor looks prohibitively expensive.
Thanks, but no thanks.