Posted by James McNeile, Partner
On 1 September 2016 Withy King LLP merged with Royds LLP. The trading name for the merged firm is Royds Withy King. All content produced prior to this date will remain in the name of the firms pre-merger.
The rise of the DIY pensioner
If you visit your local B&Q on a Wednesday, the store will be full of pensioners buying shelves, fence-panels and rolls of wallpaper.
B&Q have been clever enough to realise that most pensioners are still very active and have time on their hands – so if you give them a discount on a Wednesday, they will probably choose B&Q instead of Homebase for their do-it-yourself supplies.
The Chancellor’s astonishing “Pensioners’ Budget” on 19 March, despite all the fuss it has caused, only gave Government backing to something that had already developed an impressive momentum. For some years now pensioners have been taking their pensions into their own hands, and were clearly making a decent job of beating the pension providers at their own game.
Until 2006, if you belonged to a defined-contribution pension scheme, you were forced to buy an annuity when you retired. The pension scheme paid your pension “pot” to an insurance company, which then paid you a guaranteed pension for life.
But there were – and are, increasingly – serious drawbacks to annuities. While your pension payments can be guaranteed for up to ten years after you retire, if you die in the 11th year, the insurance company keeps all the remaining money in your “pot”. If the investment markets take off dramatically, the insurance company keeps all the gains. And if the insurance company went under (as Equitable Life came within a whisker of doing), the so-called guarantee would be worth nothing. You could lose everything.
But what really annoys pensioners these days is that annuities are very bad value for money. A man of 65 with a pension “pot” of £100,000 would now only get (at best) an annual pension of £6,170 from an annuity, and that is with no index-linking, no widow’s pension and no tax-free cash lump sum.
Why is the annuity bad value? The average life expectancy of a man aged 65 is 18.5 years. If the insurance company puts aside the £6,170 for the year’s pension from the £100,000 “pot” and invests the rest, and receives a modest return of 3% per year (say from 15-year UK gilts), at the end of the 18.5 years there is still £13,011 left. That, in very simple terms, is the insurance company’s average profit from the annuity.
But there is now another way. If at the age of 65 the pensioner does not buy an annuity, but leaves his pension “pot” invested, and draws down pension, there are a number of surprising results. The first is that the legislation allows him to draw down a higher amount – as at today’s date, it would be, thanks to the Budget, £8,850 a year, rather than the £6,170 from the annuity. Also when he dies, any remaining monies in his “pot” can be used to provide a widow’s pension. When his widow dies, the remaining money can be paid to his children or grandchildren, after tax at the children’s highest marginal rate – which may only be 25%. Why, you would ask, would anyone want to buy an annuity now?
Another less obvious result is that we have now turned the entire pension into a very long-term investment. If there is no need to cash everything at 65 in order to buy an annuity, the pension for a 30-year-old has a time horizon of over 50 years. This enables those investing the 30-year-old’s pension fund to be rather more adventurous. Instead of investing in gilts, they can invest in equities, because the inevitable volatility of equities smooths out over a 50-year period. If we assume a 7% rise per year, at least 4% of which could come from dividends, our pensioner can take his full pension of £8,850 a year from the age of 65, and when he eventually dies at the age of 83 he still has £12,000 left in his “pot”.
Now this is where the do-it-yourself comes in. In the days before the internet, reliable information on the stock market was only available to the professionals. You had to go to an independent financial adviser – which meant paying for the advice, usually by allowing the adviser to take a commission from your pension.
Nowadays this same information is available free to anyone on the web, and the “silver surfers” with time on their hands and an eye for a bargain have discovered it. They have also discovered that some websites (www.moneyextra.com is a good example) allow them to set up a dummy portfolio of shares, so that they can practise playing the stock market without risking a penny. If they are unhappy about the volatility of individual shares, they can learn about collective investments such as investment trusts, where your money is split among perhaps 100 different shares.
And it gets better. If the investment manager (whether the pensioner or someone he or she employs) is still more adventurous, and targets a return of 10% a year, the figures become even more surprising. Instead of the fund being used up, it actually grows, although the full pension of £8,850 is being drawn down continually. When the pensioner dies at 83 the £100,000 fund has grown to £108,385!
Lest anyone should think a 10% a year return is unrealistic, I should point out that the FTSE 250 Index (that is, the second-tier UK companies, disregarding the multinational monoliths) has risen by 18% over the past year, 52% over the last 3 years and 195% over the last 5 years, and a simple tracker fund would have replicated those figures.
We are rapidly becoming a nation not of shopkeepers, but of pensioner investors. In some ways it’s just the same – individuals running their own small businesses – only now we use computers and online stockbrokers rather than a counter and a till . . . .
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