I had planned a completely different post today. But, like a moth to a naked flame, I’m drawn to another post on pensions. This time, on deciding between drawdown and annuities. The catch is, you’ve still got 23 years till retirement.
The question posed comes from a This Is Money post:
I’m only 34 but my pension firm wants me to decide NOW between drawdown and an annuity – can it do this?
The post is a regular series where readers can send in questions to former Pensions Minister Sir Steve Webb. I found this one particularly interesting because it’s a question I’ve had to answer, and I suspect a large proportion of readers have also had to answer (perhaps without their knowledge!) On the face of it, it seems absurd that a 34-year-old should have to ‘choose’ between drawdown and annuities. Let’s have a little dig in.
I’m 34, make regular contributions into a defined contribution company pension, and until recently have pretty much ignored it.
I logged on to have a look at the provider’s new portal and noticed I had a new range of options which boil down to me choosing now if I think I’ll be wanting to take an annuity or a drawdown pension.
What it doesn’t tell me is how this choice affects what I might get when I hit the magic age. Which is the least ‘risky’? If I say drawdown, but later decide annuity, does that put me in a worse position than if I flipped it around?
Should I be trying to split the pots – I’ve got a couple transferred in from other places? What if drawdown doesn’t exist in the future? What if some magical new pension option appears?!
I’m not looking for the differences between the options at retirement, more about the investments which will be made now. Help?
What brought about this madness?
Steve’s response is, of course, bang on the money – I’ll do my best to paraphrase. This mad situation comes about for two reasons.
First, the ‘choice’ arises because of pension freedoms. Before 2015, almost everyone would have to use their pension pot to buy an annuity. Since the freedoms, savers can opt instead for drawdown.
Second, when you contribute to a pension and haven’t explicitly chosen an investment for it to go into, it will go into a default fund. When everyone had to buy an annuity the fund would use something called lifestyling (or glide pathing). This is where, in the years before retirement, the fund moves out of equities and into bonds. This is to cut the volatility of your pension pot in the run-up to taking an annuity.
Here’s an example from one of my pension schemes:
This is for an ‘annuity’ type retirement:
This is all very sensible, lifestyling before an annuity is one of the few things most pension experts seem to agree on. But given that you no longer need to buy an annuity, and can opt for drawdown instead, the game changes.
If you’re opting for drawdown, there is strong evidence that you don’t really want lifestyling (or at least, not as much of it). That’s because you will continue to keep investing your pot after retirement, and will want to keep benefiting from growth in your investments.
Companies will make a decision for all pension scheme members. This is reflected in their choice of default fund.
Most companies now assume that savers will take drawdown. So they changed their default fund from one that used lifestyling into one that did not. Not all companies did this, and the default fund may continue to use lifestyling.
What you do about it
You have the choice as to whether you intend to buy an annuity or opt for drawdown. If you select to go into drawdown, your investments will likely not be lifestyled. You can change this ‘notional’ choice at any time pre-retirement (although you should check your scheme rules).
You can also usually actively dictate what happens to your investments in two ways.
In the first way, you stay in the default fund but you select whether you want lifestyling or not, and the percentage of your pension contributions that go into a lifestyle investment option.
In the second you instead pick which funds you invest into (and not the default fund). Your pension scheme will offer a list of different investment options and you can ‘pick and mix’ between them.
Does it matter?
If you’ve elected to stay in the default fund (the first option above), you won’t see any practical difference in your investments until about 10-15 years before retirement. As shown in the chart above, when I would get within 10 years, the investment proportions changes. It’s around that time when you should really start thinking about whether you want to drawdown or take an annuity with your pension pot (or a mix of the two). Have a look at two previous posts of mine on drawdown and annuities on each option.
A word on default funds
If you haven’t actively selected what funds you want your pension contributions to be invested in then you are likely invested in the default fund.
Unfortunately, this is not always a good thing. The default fund doesn’t mean ‘standard’. In fact, it is a lottery whether your default fund is any good or not (link – FT google result).
It is absolutely worth taking the time to find out more about your default fund and the other fund options available to you. Generally speaking, low-cost, passively managed equity funds are what you are looking for. With these funds, you are invested in higher return assets but with higher risk. However, very few investments are absolutely certain and even government bonds can go up and down in value.
A final question
I want to round off this post with a final question:
Why do I have to make these decisions?
I’m really interested in investing and pensions (I suspect many readers are too). But most people find pensions boring and confusing. Should people have to make these kinds of decisions? As I mentioned before, I think it’s better to make saving and investing as painless as possible than to encourage forced and painful engagement.
The reality is very few people will choose the funds into which their pensions invest. The government and the financial services industry have reluctantly come to the conclusion that it’s better for people to be saving something, anything, even if it’s not perfect than to be saving nothing. Faced with bizarre questions like the one in this post today, most people will (quite sensibly!) run and hide.
Unfortunately, it is rare to find open Defined Benefit schemes. The true beauty of these schemes is not the (usually) higher retirement benefits. Rather, it’s that those savers did not need to make any investment decisions for their pension. They could get on with doing what they are paid to do and leaving the scheme to deal with the complexities of investing.
Then again, that probably means more readers for my blog…
All the best,
Young FI Guy