In the 2007/08 financial crisis, with the economy on its knees, the Bank of England, in common with most other central banks, cut its policy rate to historic lows, where it has remained ever since. While this was (and arguably remains) necessary to provide stimulus for a recovering economy, the negative implications for Britain’s savers have been especially marked.
Nowhere more has this been so than in the post-retirement market. A hitherto inflexible regime, approximately three-quarters of retirees buy an annuity at retirement according to government figures. The costs of annuities have soared in this time of ultra-low interest rates, with gilt yields – the reference asset for annuities – at historic lows.
It is a depressing fact that Britain’s typical retired couple needs a pension pot of £955,000 – alarmingly close to a million pounds – to buy an annuity that generates the UK average income of £26,884 for each partner. This is made worse because it includes no inflation protection, passes on just 50% of the income to a surviving spouse and cannot be passed on as an inheritance to future generations.
The rules around annuities have been “relaxed” to some degree over the last few years, which would appear to indicate a widespread acceptance that the existing regime was unnecessarily restrictive. It might even be described as proof that the system simply wasn’t working. However, it is only with the wholesale changes announced in the March 2014 Budget that Chancellor of the Exchequer George Osborne has fully recognised the scale of the problems.
Well-timed proposals
Mr Osborne’s proposals are timely. With the baby boomer generation now in or at the point of retirement, from April 2015 the government estimates there will be 320,000 British retirees with DC pension pots annually looking to access their savings.
While annuities are guaranteed, this has also been their downfall because it is their guaranteed nature that has made them so expensive. A more effective solution to this problem is to remain invested, an option that from April 2015 should be available to everyone. Whilst this may seem like a risky option, that is to ignore the real risks that today’s retirees face.
What are these risks? And how should we address them in a post-retirement solution that is fit to take on today’s problems?
I believe that these risks are best addressed by an investment portfolio that is designed “from the bottom up”, rather than by re-purposing existing investment strategies which are often designed to accumulate wealth rather than to live off it. Old Mutual Global Investors has long been an innovator in this area, our established Old Mutual Generation range of funds demonstrating our credentials in the management of solutions designed to meet retirees’ needs.
In arriving at an appropriate asset allocation for such a portfolio, there are two key considerations: income and inflation.
To preserve living standards in retirement, protection from the effects of inflation is critical. For many people, the point of retirement is the point of greatest wealth; savings that have been accumulated over many years of hard work. But this wealth is illusory without protection from inflation which can eat away at the purchasing power of savings over time.
While we all have our own real life examples of the wealth destroying nature of inflation, the cold hard maths of compound interest are more compelling: at 3% inflation, we lose almost one third of purchasing power in just 10 years and almost half over 20 years. Someone retiring today would expect to live 20 years and a 3% inflation assumption is conservative. For the couple who retired at 65 with a combined pension pot of £955,000, and with one spouse dying after 20 years, the surviving spouse’s annual income would be worth just £14,800.
We believe that real assets such as infrastructure, commodities and property can play an important role in retirement-optimised portfolios. A truly multi-asset approach can make a real difference.
Retirees also need to take an income. But drawing down from an investment pot when markets are down can have a negative effect on the long-term value of the capital. Pound cost averaging works “in reverse” in drawdown: assets sold at low points hurt wealth more – a negative compounding effect.
As such, significant drawdowns in the early years of retirement can have a disproportionately negative effect on the longer term prospects of a pensioner. In an extreme, getting this wrong can lead to the “risk of ruin” – in other words, running out of money. This is precisely why it is so important that a retirement-optimised portfolio’s asset allocation remains focused on income generation from its underlying assets, living off the portfolio in a sustainable way.
Launched in November 2012, the Old Mutual Generation funds aim to provide investors with an income from their savings whilst growing the assets ahead of the rate of inflation over time. Being designed from the ground up to do this, the funds have delivered strong positive absolute returns over this period and we believe they are exactly the right kind of innovative solution to fill the annuity gap that now exists.
Annuities offer poor value for money and the Chancellor’s recognition of this in his 2014 Budget is a tremendous step forward for Britain’s long-term savers.
