Three years after The Spectator called on the Chancellor to ‘stop treating pensioners like babies’, his Budget this year gave everyone greater choice about how we enjoy our life savings. While more column inches have been expended on the outside chance that some pensioners might blow the lot on a Lamborghini, less has been said about our exciting freedom to retain control of the biggest fund most of us will ever acquire and to remain active investors after we retire.
Contrary to what some commentators seem to imagine, George Osborne did not abolish the legal compulsion to spend most of our pension savings on an annuity or guaranteed income for life last month. He began that process in his 2011 Budget, when he scrapped the requirement to use at least three quarters of the pension fund to buy a guaranteed income for life. I congratulated him then, in these pages, and urged him to go further.
Well, now he has done so. And how.
The problem with the 2011 settlement was that only the wealthiest pensioners could choose how they spent their savings because of what was known as the ‘secure income’ test. Secure income is defined as state pensions, annuities and/or final salary or defined benefit pensions. Under the 2011 rules, you had to show a secure income of £20,000 a year before you were granted complete freedom to spend the rest of your pension pot; and at present, for a 65-year-old, an annuity yielding that much secure income would cost nearly £360,000.
The idea of the secure income requirement is to prevent pensioners’ savings expiring before they do. That remains a real risk under the new rules, which pensioners should bear in mind when considering what investment strategy suits them best. Some may decide that the certainty of an annuity is worth paying for — even when that means irrevocably transferring their capital to an insurer and locking into fixed yields near historic lows. The Chancellor has done nothing to restrict that choice but, most importantly, he has extended the right to opt out.
As a result of Budget 2014, the secure income required is now only £12,000 and — subject to consultation — the Chancellor has proposed scrapping the secure income test altogether after April 2015.
There is no reason to suppose that many of us who were prudent enough to save voluntarily for our old age will suddenly turn into spendthrifts when we retire. One important deterrent against taking too much out of pensions too soon is that all withdrawals — after the allowance to draw 25 per cent as tax-free cash, which hasn’t changed — will be subject to income tax at the individual’s top rate.
So someone could end up paying a huge sum in tax if they withdrew all their pension to indulge themselves. Assuming they had already made use of their personal allowance and lower-rate bands of income tax, they would need to withdraw more than £227,000 and pay 45 per cent tax on it to be left with the £125,000 price of a Lamborghini Gallardo. Even bigger tax liabilities might be incurred by anyone seeking to use their pension to buy property, now that the average house price is over £178,000.
Against all that, many people may very well wish to spend more of their life savings sooner than would have been allowed under the old rules. It’s not unreasonable to consume more in the early years of retirement, while you are young enough to enjoy it, when frailty in advanced old age could prevent you doing so. Why not travel in style now, rather than wait until the dismal day when a trip to the dustbins and back might seem like a bit of an adventure? What right has the government to interfere in such decisions?
Self-interest is the only motivation you can always rely on and individual investors will probably prove much better guardians of their life savings than the man in Whitehall — or the wiseacres at the Guardian. Never mind the scare stories, rising life expectancy means most pensioners will aim to draw a decent income without excessive capital erosion.
That means investing for the long term rather than a short sprint. At age 65, the average man can expect to live for another 18 years while the average woman can look forward to nearly another 21 years, according to the Office for National Statistics.
Taking that sort of timeframe as the target period for investment, shares reflecting the broad composition of the London Stock Exchange have tended to outperform other asset classes in the past. Analysis stretching back over more than a century shows that shares delivered higher returns than bonds or cash deposits during nearly nine in ten periods of 18 consecutive years. To be precise, shares beat government gilt-edged stock in 88 per cent of these periods and outperformed cash deposits 99 per cent of the time.
The past is not a guide to the future, however. Asset prices may fall and you might get back less than you invest. Pooled funds — such as exchange traded funds (ETFs), investment trusts and unit trusts — seek to diminish that risk by diversification; spreading individuals’ money over dozens of different shares to reduce exposure to setbacks or failure at any one company or, in the case of international trusts, any one country.
So far, so familiar, but few investors are aware of a major distinction between different types of pooled funds that could prove particularly important to pensioners. Unlike unit trusts and ETFs, investment trusts can retain up to 15 per cent of dividends from their underlying holdings in good years to top up income payouts in bad years. Income is important to pensioners who must live off their savings, and this unique ability to smooth dividend distributions has enabled some investment trusts to maintain or increase income payouts for several decades.
While it would be wrong to underestimate the risk inherent in stock markets or to denigrate the capital guarantee provided by annuities, it must be a good thing to allow everyone — not just the rich — to decide what we do with our life savings. As I pointed out in this space three years ago: ‘It’s our money, we saved it, and now more of us are free to decide how we finally spend it.’
Ian Cowie is a columnist at the Sunday Times.