Transcript: How To Maximise Your Pension

Published in Investing on 26 September 2011

David Kuo talks to Billy Burrows from Better Retirement Group.

You can listen to or download this podcast here.

 

David:

This is Money Talk, I am David Kuo, and a recent report from Prudential showed that pensioners are set to lose 60% of their spending power over the next twenty years.  This means that someone retiring on an income of £20,000 a year will only get £7,800 in today's money, in twenty years' time. Essentially they will see a pay cut of around £12,000.  Is there anything we can do about this?  Let's find out from the UK's leading annuity expert, Billy Burrows from Better Retirement Group. Welcome to Money Talk, Billy.

Billy:

Thank you.

David:

You know, the last time you were here, you had a lot of responses from our listeners about what is going on with their pensions, and people are truly terrified, if not confused, about what is happening to their retirement pot. So, what is going on, Billy?  What is causing pensioners to see a drop in the spending power over the next twenty years?

Billy:

Well, the Prudential report is looking at the question of inflation.  As you know, people are being told to shop around for the best annuity, and there are basically two types of annuities: annuities that provide level payments, and annuities that start much lower, and are inflation-proofed.  Now, if I give you an example – if someone's got £100,000, and they're sixty, they can get probably just under £6,000 a year as a level annuity, but if they buy an inflation-linked annuity, an annuity that keeps pace with inflation, it's about £3,500.  

Now, faced with the choice, do you want £6,000 a year, or do you want £3,500, you can guess which one people are going for.  Now of course, the problem is that people are making decisions about an annuity that could be in payment for over twenty years on short-term criteria, ie, who's paying me the most income.  So it's a real problem, and I think my own view is that inflation is like sin: every government denounces it, but they all practise it.  Pensioners ignore inflation at their own peril, so they must look at ways of taking a slightly lower income at retirement in return for the potential for future income growth, in order to keep pace with inflation.

David:

But Mervyn King, the Governor of the Bank of England, is telling everyone that inflation over the long term should return to the long term average of 2%, or the government's target of 2%.  Are you saying this isn't likely?

Billy:

Well, I mean it's possible, but I think it's deeper than that, and I think you have to ask yourself, what is the actual inflation rate for pensioners?  I mean, take my kids – for them, the stuff they're buying, the iPads and the computers, they're all coming down in price, but people in retirement, they have to spend more money on fuel, money on holidays, on food, increasingly on care at home, and all these things are going up at a much faster rate than a lot of the consumer durables.

David:

But before we go into the nitty-gritty of annuities, there will be some people out there, for instance, my son, who will be saying, "What exactly are annuities, Billy?"  So can you explain, in simple terms, what an annuity is?

Billy:

An annuity is simply, it's a policy that takes a lump sum, typically from a pension fund, and then converts it into a stream of income in the future.  You could think of it almost as a mortgage in reverse.  If I'm an insurance company, you would invest your money with me, your £100,000.

David:

Why would anyone want to do that, Billy?

Billy:

[he laughs] And then, what I would do is, I'd pay you back effectively the capital and interest, no matter how long you lived.  Now, the biggest criticism about annuities is that, if you die early, the payments stop, but of course the other thing is, if you live to be 100, and people are living longer and longer, then the insurance company has to carry on paying you until you finally drop your clogs.  Now, the other part about an annuity is that there's this mortality cross-subsidy.  Those that die early pay for those that live longer than anticipated. 

David:

So how do they work out these annuity rates?  What are the various things that they put into this black box to come out at the other end with an annuity rate for you, or me, or for anybody?

Billy:

Well, there are three key ingredients. The most important ingredient is average life expectancy, and a man of 65 can expect to live for another eighteen or twenty years.  The second ingredient is the underlying interest rate insurance companies have to invest in, long-dated gilts and corporate bonds, so the yield on those is important, and thirdly the insurance companies' expenses, and they're all put into the box to provide the annuity rate.

David:

One of the big criticisms at the moment is that women tend to get higher annuity rates than men.  What is the reason for this?

Billy:

Well again, annuities are based on longevity, so the longer your anticipated life expectancy, the lower the income, because obviously the income's got to last longer.

David:

But there are going to be changes there, aren't there?

Billy:

That's right – it's this European directive on gender-neutral insurance pricing.  So at the moment, insurance companies can offer different rates for men and women, because of the different life expectancies, but under the new rules from December 2012, they'll have to price without taking gender into consideration.

David:

So what will they use instead then, if they can't use gender?  Surely, if the statistics show that a woman lives longer than a man, therefore her annuity rate should be lower than a man's? – I find that to be quite fair, so why are they changing these rules?

Billy:

Well, they're changing the rules because of the Sex Discrimination Act, but the problem I have with it is that one of the unintended consequences is that many ladies will end up worse off, not better off, and that's because most women benefit from the joint life annuity, and if the rates for joint life annuities fall, then obviously that'll affect a lot of women. So the only women that will benefit are single ladies.

David:

Now then, one of the things about annuities, as you alluded to earlier on, is linked to long-term gilt yields.  So, given the turmoil in the bond market at the moment, how are annuity rates going to be affected?

Billy:

Well, at the moment we have this so-called double-whammy: annuity rates are falling, and in fact in August annuity rates fell by the largest amount in a month since I can remember.  So annuity rates are falling; also equity prices are falling, so those people who are foolish enough not to move their pension funds into safer assets as they approach retirement, are finding that the funds are down and annuity rates are down.

David:

So why is there this rule that the money that I hand over to an insurance company or to a pension company has to be invested in annuities? Why can't they invest in anything else that produces a higher yield?

Billy:

Aha – well, you can, because at retirement you can choose to invest in an annuity, or what is called pension drawdown.  Now, pension drawdown is relatively easy to explain: you keep the money in the pension pot, the government have a rule about how much income you can draw down, and it's rather like having your money at the building society – every month you draw a certain amount out.  But the problem with drawdown is that it's normally invested in the stock market, so as time goes on, the fund value could be falling as you take more income.  So drawdown is more flexible than an annuity, but also it's actually a lot more risky, because you could, in theory, run out of money.

David:

But Billy, some people are saying that annuity rates at the moment are anomalously low; in other words that people are so terrified about the stock markets, so consequently they're putting their money into safer investments.  Why the US dollar is safe, I don't know, but people are piling into US treasuries; people are piling into UK gilts; people are piling into Swiss francs, Japanese yen, for what reason I have no idea, and also gold.  So therefore, wouldn't you say that the bond market at the moment is just anomalous?  So if you were thinking about taking out an annuity, it would be better to wait for the bond market to return to some kind of normality before you actually buy your annuity?

Billy:

Intuitively, yes, but in practice, it's far more complex than that.  Let me first of all deal with annuities. The sceptic in me has always said that insurance companies are quick to cut the rates when the yields are falling, but slow to increase the rates when the yields are rising. 

David:

But there is competition out there though, isn't there? 

Billy:

Well, is there competition?  I mean, if you look at the annuity market, the annuity market is in two parts – annuities for people in good health, and there's only really three main players there: Aviva, L & G and Canada Life, so yes, there's competition, but it's limited.  The other type of annuities are for people in poorer health, where you can get a larger annuity because of your potentially reduced life expectancy, and there's more competition there, but it's basically just retirement and partnership, and companies like MGM.  So there isn't an awful lot of competition; in fact we would like to have more competition.

David:

But if long-term gilt yields at the moment are 3%, Billy, and inflation in the UK is at 5%, and we expect inflation to increase over the next few years, surely it would be better to wait until those annuity rates come back to reflect what the long-term inflation rate is going to be, which could be as high as 5%?  Given how much money is being pumped into the economies in Europe, the UK and also America, eventually that money will fuel inflation?

Billy:

I think the intelligent comment about predicting future annuity rates is, yes, we expect bond yields to increase, but – and this is the big bug – it's unlikely that the full benefit of any increase in the yields will be directly passed on to annuitants.  As insurance companies hold money back to cope with this gender-neutral pricing; we having talked about Solvency II, where insurance companies have to hold back more capital for their annuities; and also people are living longer.  So yes, I agree the bond yields will rise, but I don't think annuity rates will rise proportionately.

David:

Okay, so let's have a look at annuities, maybe two or three specific annuities, the first one being level annuity that you already alluded to.  How does this work?  What are the pros and the cons of level annuity?

Billy:

Well, a level annuity does exactly what it says on the tin. 

David:

Which is?

Billy:

You invest your £100,000; the insurance company will say, we'll pay you £5,600, or £6,000 a year, and that will be paid in monthly instalments through thick and thin, for as long as you live.  You could have an option that, if you pre-decease your wife or partner, the annuity will carry on until they've passed away.

David:

So what are the cons?

Billy:

Well, the cons, and you alluded to that in your opening comment – it's inflation.  Inflation reduces the spending power of your annuity over time.

David:

But doesn't it also mean that, if you think you are not going to outlive the estimates provided by the insurance company, then you should take a level annuity?  In other words, if you are in pretty ill health, why would you want an annuity that is increasing over time, when you're not going to be living that long?

Billy:

I think I'd put it a slightly different way, in that you can argue that it's logical for people to take the level annuity because they want to consume the level of spending income in the early years of retirement, but to do so, people have to have other assets to cope with inflation in the future.  There's a bit of human nature of it – people are making decisions about what is a long-term income stream on some very short criteria, which is, how can I get the most income and spend it as fast as I can?

David:

Okay, so let's have a look at the next type of annuity, which is the increasing annuity.  How does this work, and again what are the pros and cons of increasing annuity?

Billy:

Well, an increase in an annuity would typically start 30, 35% lower than the level of the annuity, and then each year it'll increase either by a fixed amount, say 3%, or by inflation.  The advantage is obvious, that as time goes on, the annuity payments increase.  There's actually, I think, a slightly different question to ask about, the question between a level and an inflation-linked, which is, which offers the better value for money?

David:

So tell me, which offers the better value for money, Billy?

Billy:

Well, I'll answer that by saying that, in the past, and I suppose five years ago, my actuary clients and investment bankers would voluntarily buy inflation-linked.  Now, very few people are buying inflation-linked annuities, because they're so expensive.  So I guess that's the answer – inflation-linked annuities appear to be poor value for money.

David:

You mean, it is because they start at too low a level in order for you to actually make it up as you go along in time?

Billy:

Correct, and if you were to do a graph, typically it takes anything up to 12, 13, 14 years for the increasing annuity to catch up with the level annuity.

David:

So between the two, you would actually go for the level annuity rather than the increasing annuity, even though the latter sounds more seductive?

Billy:

Ah, well ... no, no – I'd take a slightly different approach.  My approach is to say to clients, you actually have to think about your income requirements in the future, and you really do need to find ways in which you can have an increasing income to increase with the ever-increasing cost of living.  There are various ways of doing that, and of course the most obvious is actually to invest some of your money in a level annuity, and some of it in an increasing annuity.

David:

So you can actually do that? – you can split it as you wish?  You don't have to say, the whole lump sum is going into a level annuity?

Billy:

You don't have to.  Behind the scenes, it sometimes can get a bit complex, but we do this for customers all the time, and especially when we recommend investment-linked annuities.  An alternative to investing your money in an inflation-linked is to invest in an annuity that's linked to equities, whether that's through a with-profit fund, as with the Prudential, or MGM's investment-linked annuity.  The idea there is that the investments will provide growth which then means that the income payments will increase over time, but of course people are taking the risk that, in the future, the income could be less, not more.

David:

The third type of annuity is enhanced annuity.  Can you explain to me what an enhanced annuity is? – because that really sounds seductive.

Billy:

Well, an enhanced annuity is dead simple.  If you're in poor health, if you have heart problems or a stroke, or if you smoke; even if you're overweight, the insurance companies will say that, in order to compensate for your below-average life expectancy, we'll increase the payments.

David:

Now the thing is, Billy, what you are actually saying makes an awful lot of sense, but one of the downsides of what you're saying is that people are almost at the point where they think, well – what is the point in investing for my retirement, Billy? – because I spend maybe 30, 40 years of my working life putting money to one side, and then I reach my retirement age, and then I'm faced with this problem of what to do with my pot of money. That pot of money could be somewhere between a hundred and half a million pounds.  Then they think, well – why I am doing this? – because I'm going to end up with not an awful lot of money; it's all going to get eaten away by inflation, and no matter which option I take, whether it is level annuity or increasing annuity, I'm still going to get hammered.  It's almost like being kicked in the teeth, having done what I was supposed to do.

Billy:

I think your question's a bit flawed, because it doesn't matter whether you've got your money in a savings account, in a building society, in a pension – you've still got the same issue.  To put it bluntly – you retire; yes, there's a state pension, but any income over and above the state pension has to come from your own resources.  It just so happens that a pension is actually a very tax-efficient way of saving up.

David:

So too is an ISA?

Billy:

Correct, but again with an ISA, if you have an ISA at retirement, you still have exactly the same issues – how much income do you take?  Where do you invest it, and if you take too much income, you run out of money.  So the problem isn't necessarily with annuities; the problem is that we're all living longer, we're all spending a lot more money in the past.  So the objective for most people at retirement is how they can plan to have an income that's going to last them for as long as they live, and actually allow them to live the lifestyle that they want.

David:

Okay, now given that we have to save in some form or other for our retirement, the government is bringing into the arena NEST schemes, or the National Employees' Savings Trust.  In other words, anybody who is in work will have to contribute towards this scheme.  What is your view on NEST?  Does that make sense to people?

Billy:

Well, I think my view on NEST is fairly straightforward.  There's a group of people who don't earn very much who need to take some pretty complex advice, because it may well be that, for every pound they save up in a pension, they're losing the equivalent in benefit, but leave those people aside.  For most people, having some sort of pension must be better than having no pension at all.  So I honestly think that the key to getting people to have a better retirement is to get them to take some ownership, to engage in their pensions, and if by auto-enrolment people automatically sign up to a pension scheme, then it's not necessarily a bad idea.  But again, to repeat, there may be some people where it's inappropriate, and I do wonder who's going to tell those people that it's inappropriate for them.

David:

Now then, in what you do, you must have people coming up to you and saying, give me some advice on what to do with my pension pot.  What do you reckon is the average size of the British worker's pension pot at retirement?

Billy:

The short answer to that is, the average size of the UK pension pot is only £30,000.  But that sort of hides the fact that we're seeing three types of customers.  We're seeing a group of people which I'd politely call "bread and butter Britain" who have pension pots probably below £50,000. We then have the mass affluent, or what I call the middle Britain group, who on average will have a pension fund sort of probably around £100,000; and then the so-called fat cats, who have got the half a million pounds.

David:

What is your advice to those three separate groups of people?  If I came to you as a bread and butter saver, what would you say to me with my pension pot of £50,000?

Billy:

I think the message is, really you need to get as much income, to obviously shop around.  Most people will buy the level annuity, although I think they should take inflation more seriously.

David:

So what would I get for my £50,000 pot, then?

Billy:

Well, if you're lucky, you might get £3,000 a year.

David:

That's not an awful lot, is it, in today's climate?

Billy:

It's not at all.

David:

So the second group of people, the middle Britain, with their half a million pot – well, somewhere between a hundred thousand and half a million pounds – what can they expect in terms of annuities?  With a bigger pot, can they drive a better bargain?

Billy:

It's not so much about driving a better bargain.  It's actually, I think, about encouraging people to think about their pensions in the same way as they would with their savings.  You wouldn't tell somebody, on retirement with their savings, to put it all into bonds, or all into equities.  You would say, have a bit in both.  Increasingly, with people who are taking my advice, they're investing part of their funds in a level annuity, because it gives them the security and the high rate; they're investing some of their money in these investment-linked annuities, because the attraction there is the longer-term growth; and they're investing some of it in drawdown, because that gives them the flexibility.

David:

So how much would you need in order to qualify for a drawdown?

Billy:

In practice, you'd probably need over £100,000.  I don't have an issue with people who've got smaller pots, providing they've got other sources of income or other assets.  But to run a drawdown properly, you probably need about a quarter of a million pounds, because you have to have some pretty sophisticated investment advice.

David:

And for the fat cats, the people with over a million pounds in their pot? – are you saying that they don't really have to worry a great deal, because they're going to be pretty comfortable anyway?

Billy:

The interesting thing about fat cats is, a lot of the fat cats actually find annuities very attractive, because they pay a guaranteed income.  I think one of the things that we're seeing now with the so-called fat cats is, they can take benefit from this flexible drawdown. Flexible drawdown, in a nutshell, means that, providing you can show that you have over £20,000 of guaranteed income, state pension and annuities, then within the limits you can do exactly what you like with the balance, and you obviously pay tax on any income you take.  But pension planning is getting much more flexible now, for those people that have got big pension pots.

David:

So what is the advice for people with a significant amount of money in their pension pot?  What would you say should be their first port of call – to go see their accountant, or something?

Billy:

I would politely suggest they need to see a retirement specialist. The reason is, is that in most walks of life, if people follow their own intuition, they'll end up in the right place, but at retirement, if people follow their own intuition, they could end up in the wrong place.  Let me give you a good example of that. With a lot of the wealthier clients, they're saying, why do we need to take money from our pension? Why don't we just take no income, and leave it to the kids?  Then, of course, I make the point that you should really use your pension as the first port of call for your income, because for every £1,000 of income from your pension pot, it's a £1,000 of your own savings that you're not having to use as income. 

David:

So what's the difference?

Billy:

Well, the difference is that, on death, from a drawdown plan, any remaining balance will be taxed at 55%; whereas with your own funds, yes there's inheritance tax, but actually if you take the correct advice, you may be able to mitigate it.  So the point being, for a lot of people who have significant pension funds, the advice could well be to take as much income as they can from their pension funds, because then that means that they've then got more flexibility with their own savings to make inheritance tax planning.

David:

Okay, now I'd like to end by looking at a final story, and it is one that really infuriates me.  This concerns national insurance, which all of us workers have to pay.  Now, it is reckoned that workers in their fifties and sixties are wasting £11 billion a year collectively paying national insurance.  The reason why they're wasting it is because they've already paid enough contributions to get a full state pension anyway, so paying more national insurance doesn't entitle them to a higher pension.  What do you think should be done to change this?

Billy:

That's a very good question.  I think that the first thing people need to do is, as they approach retirement, is to get a pension forecast.  You can fill in a very simple form and then the Department of Work and Pensions will give you an estimate, so you can work it out.  But I think what you're really saying is that the state pension is so complex, that very few people can really understand what's going on.  So I think there are two things: people have got to go to the trouble to understand a bit more about state pensions, and I think the state has actually got to make pensions more simple.

David:

And this is where they're coming up with this idea of the universal state pension? – in other words, everybody gets the same amount on retirement, I believe it's around £140 a week, and that's it.  So regardless of what you pay in, everybody gets £140, regardless of what kind of benefits, or how rich you are, or how poor – everybody gets the same amount.  That would be simple, wouldn't it?

Billy:

Well, it'll be simple; whether it's fair or not is another matter.  But of course, the point is that, in today's world, the state pension only provides a fraction of the income that people need in order to live a meaningful life.  So people must save up, either in a pension or in their own personal assets, otherwise they'll have a disappointing retirement.

David:

But I think the key to the universal state pension working is that the government will try and work out almost to the day what is the life expectancy of the average Briton.  In other words, if the average life expectancy is 75, they will pay you this universal state pension from the age of 74, so you get one year's worth, and that's it.  So it sounds nice in theory, but I think in practice, it would be far too expensive for them to do that.

Billy:

Well, like all these things, there's some winners and there's some losers.  If you're on the winning side, it's great.  If you're on the losing side, then clearly it's not very good. 

David:

Yeah, so what is your advice for people listening to this podcast? – anybody who is just starting out work, say, at the age of eighteen or twenty?  What should they be doing now?  Should they bother with pensions at all?

Billy:

Oh yes, I mean they should definitely invest in a pension.  But I think the big difference between the world today and the world in the past is, in the past people had it on a plate.  Nowadays, people have to take more care to understand what's going on.  They need to get more involved with their pensions. 

David:

And how do they do this?

Billy:

Well, they do it a number of ways.  First of all, they need to educate themselves.  There's some good websites now – your website, my website and other people.  They need to talk to financial advisors, and they need to monitor what's going on, they need to plan.  I think the learning I have from advising people over the last twenty years is, those people that have had a plan have ended up in retirement in good shape.  Those without a plan have ended up in pretty poor shape.

David:

Now, people know the name of our website, which is fool.co.uk, but what is the name of your website, Billy?

Billy:

Williamburrows.com.

David:

Williamburrows.com, so thank you very much for coming in today, Billy.  Now for a quote to sum up today's podcast.  I'm sure you're waiting for this expectantly at the moment.  The quote comes from Anon, who says: "Freedom is never free".  In other words, if you want financial freedom when you retire, then you will need to pay your dues today. 

 Billy:

I agree with that.

David:

You do agree? – thank you very much!  Now, this has been Money Talk, I have been David Kuo, and my guest has been Billy Burrows from Better Retirement Group.  If you have a comment about today's show, please post it on the Money Talk web page, which you can find at fool.co.uk/podcast.  If you have a suggestion for future shows, please do let me know at moneytalk@fool.co.uk.  Until next week, happy investing!

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Comments

The opinions expressed here are those of the individual writers and are not representative of The Motley Fool. If you spot any comments that are unsuitable hit the flag to alert our moderators.

jaizan 26 Sep 2011 , 9:48pm

Cross subsidy? I don't see it.

A 3.5% annuity rate for index linked annuities seems abysmal.

After all, it should be possible for the pensioner to buy a basket of stocks yielding 5% or so AND see that increase with inflation during his lifetime AND have the lump sum left over at the end.

Annuities seem like a major disincentive to invest in pension funds.

Under current rules, I would put any money taxed at basic rate into an ISA ahead of a pension.

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