Pension freedoms granted to us by the coalition government in 2014, which allowed us to do what we liked with our pension pots when we reached retirement, haven’t gone well for some. Last year, 253 victims reported to Action Fraud that they had been defrauded by an average of £91,000 each. The regulator, the Financial Conduct Authority (FCA), believes this is just the tip of the iceberg as many defrauded do not report. It thinks that more than 100,000 individuals were scammed out of their pension savings last year — cold called and offered money-making schemes, only to discover later that their money was gone and the ‘adviser’ nowhere to be found. It’s got so bad that the FCA is now running a television ad with the Pensions Regulator to warn consumers about pension scams. It features a distraught defrauded couple and the conman water-skiing in a luxury beach resort at their expense.
It’s enough to make you hanker after the days when we were forced to buy annuities with our maturing pension pot. That meant selling our shares and bonds held in our pensions to buy a product that pays us a certain income each year for the remaining years of our lives. At least in those days we only got moderately ripped off, not defrauded of our entire pension savings.
Yet it is not a route that many choose to take. Sales of annuities have fallen more than 80 per cent since 2013. So can an annuity be a good choice? Not in my mind. The method of calculating your annual income is complex, based on how long you are likely to live, future interest rates, investment returns and inflation rates. None of these things is accurately forecastable, so it’s difficult for you, or me, to check if the annuity deal is a good one or not. My rule? The more opaque a financial product, the more likely it is you will be ripped off. In a low interest rate world, annuities also offer poor value for money — unless, that is, you are confident of living much longer than the average annuity customer.
So if not an annuity, then what should you do with your pension pot? One simple choice is to transfer most of your stock market investments into bonds — which are interest-bearing IOUs issued by companies or by the government. Bonds — or ‘gilts’ as they are often called when issued by the government — are a lot less risky and volatile than shares, and in the past would not have been a bad choice. For most of the 1990s and 2000s the ten-year gilt yield (the interest rate the UK government pays you if you lend them money for ten years) was about 5 per cent. So owning £100,000 of ten- year gilts I would get £5,000 a year income, as well as the return of my £100,000 capital in ten years’ time.
The risk is that high inflation might have eroded the real value of my £100,000 when I get it back. But a bigger problem in buying gilts is that thanks to quantitative easing, the interest rates on them have plummeted. I will only now get 1.4 per cent interest a year if I lend the government cash for ten years — a mere £1,400 a year from a £100,000 pension pot.
Another option is a buy-to-let property, but the government has made that far less attractive from a taxation point of view. I would now have to pay an extra 3 per cent stamp duty on an investment property. And as part-owner of a large family home, I am overexposed to the UK property market already. I like to diversify my assets to reduce risk.
I am certainly not going to be convinced that cryptocurrencies are an investment, so I am left with really only one option: keeping my cash in the stock market and drawing off income as a I need it. The FTSE100 currently has a 4 per cent dividend yield, which means that if I invested £100,000 in an index-tracking fund, I would get paid £4,000 a year in dividend income — more than twice what I would get from bonds. This income is not guaranteed and could easily fall in a recession — although it could also rise.
Shares are a natural hedge against inflation — if it does creep back, share prices are likely to rise as well. That’s because companies will increase their prices as inflation goes up and so their revenue and profits (and share price) will increase too. Individual shares can be very volatile, but as long as you own many different stocks across the world, that volatility or risk is reduced. When I do retire I might expect to live another 20 years, which is still a long enough time to stay invested in the stock market and cope with the ups and downs.
Most people have time horizons far longer than they realise — I’m 48 and so my pension will be invested for at least another 30 years. That is long enough to cope with the volatility of shares and be rewarded for investing in the market for the long term.