Managing my money
Managing my money

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Managing my money

7.2 Personal pensions

In this section, you will look at personal pensions and the pensions revolution unveiled by the government in 2014. You will also look at the move from final to average salary pensions and apply the financial planning model to pensions.

Figure 5

Personal pensions and defined contribution occupational schemes are examples of defined contribution schemes, and all work in essentially the same way. The pension depends on:

  • the amount paid in, which is invested in a pension pot
  • how much the invested pension pot increases in value
  • how much is taken out of the pension pot in charges
  • how much the saver decides to draw out as a cash lump sum at retirement
  • how much pension the remaining pot can buy at retirement (most commonly the pot is used to buy an annuity, but an alternative is income drawdown).

Anyone can have a personal pension and anyone can pay into a personal pension for someone else – so the main earner in a couple could pay into a plan for a partner who has a caring role.

Personal pensions (unlike occupational defined contribution schemes) do not necessarily offer a package of benefits. It‘s up to the individual to choose whether to buy extra benefits, such as life cover, a pension for a partner or increases to the pension once it starts to be paid.

Personal pensions and occupational defined contribution schemes expose the individual to a variety of risks. To understand these risks, put yourself into the position of someone who is currently many years from retirement and who has to organise their own pension scheme to provide themselves with retirement income.

How much should you pay into the scheme? It’s important to get this decision right because if you pay in too little, your pension will be too small. Pay in too much, and you could limit your current spending and standard of living, but you can’t be certain of the correct amount. The eventual cost of the pension will depend on these factors.

  • Investment returns: as you saw in Week 5, when investing for the long term – and pension savings are very long term – stock market investments, like shares and bonds, are likely to be most suitable. It’s impossible to know in advance how well these investments will perform. If, in planning for retirement, you assume they will perform well, you don’t need to invest too much. If your assumption is wrong and the investments turn out badly, you’ll have too little in your pot to provide the pension you wanted. What counts here is the investment return after all the charges have been deducted. An investment fund that offers the chance of higher returns but has high charges might be a poor choice compared with a less ambitious investment fund with modest charges.
  • Inflation: Week 2 described how rising prices reduce the buying power of money. To protect against this, you would need to invest extra money to compensate for the effect of inflation both over the years when the savings are building up and once the pension starts. But you’ll also have to estimate what rate of inflation to guard against. If your estimate is too low, in real terms you’ll have a smaller pension than planned.
  • Longevity: the aim is that the pension, when it starts, will provide a regular income, usually paid monthly, until your death. The longer you live, the more months of pension that have to be paid out, and the greater the total cost of the pension. In deciding how much to save, you need to make an assumption about how long you will live or the cost of insuring against living ‘too long’. If your assumption is wrong, either the money will run out before you die or you’ll have saved more than you needed to.

Therefore, defined contribution schemes, including personal pensions, lead to individuals shouldering the risks up to the time when the pension starts. This means that different people saving the same amount can receive very different pensions, and a person’s pension can be markedly different depending on when they retire.

On reaching retirement, you can protect yourself from further longevity risk by buying an annuity that will provide an income for the whole of your remaining life, however long you live. In effect, this is insurance against living for longer than your pension pot would otherwise last. However, the annuity provider will take a slice of the pension pot in charges before what remains is turned into income.

A revolution to defined contribution schemes, however, has been presaged in the 2014 budget statement by the Chancellor George Osborne. He announced that restrictions on pensioners’ access to their pension pots are to be eased from April 2015, with a quarter of pension pots able to be withdrawn without any liability to tax.

Thereafter withdrawals will be taxed effectively as income. The government plans to end the requirement for defined contribution pensioners to buy an annuity. Those retiring will instead be able to access their pension pot and invest it where they choose to provide an income in retirement.

Listen to our personal finance expert Jonquil Lowe talk about the proposed reforms to pensions announced in George Osborne's 2014 budget statement and about the risks associated with pension planning. This was first broadcast on Bolton FM (16 March 2014).

Download this audio clip.
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Transcript

JONQUIL LOWE:
The really surprising issue was this change with pensions. So from 2015, instead of having to buy an annuity, which is what most people do with their pension pot, there will be total freedom to take your pension savings when you like and whatever form you like. So you could take it all out as a lump sum, if you wanted-- blow the lot at the start of retirement.
It wouldn't necessarily be terribly sensible, and certainly at the Open University, the personal finance courses that we deliver are all about being savvy with money and understanding long term planning. But what it might do is really put a bomb under the annuity industry, and get the insurance companies to come up with better products for retirement.
INTERVIEWER:
You don't think that the ability to take the whole lot as cash, if you like-- does that not undermine the predicted shortfall in people's pensions?
JONQUIL LOWE:
Yeah. I think it's very curious policy, actually. Because on the one hand, we've got automatic enrollment. The government has said, people-- leave them to themselves.
They don't make wise decisions. They don't save enough for retirement. So let's give them a nudge by automatically enrolling them into workplace pensions.
And then the complete opposite-- they're saying, OK, when it comes to retirement, you are a responsible person. You can make good choices. And we know that people are driven, to some extent, by their emotions. And spending money today is much more attractive than putting it aside for the future, which is kind of uncertain and it's a long way off.
And even the government's own figures-- they show that they're expecting the tax take from taxing pensions to go up in the years covered by their forecast because they are expecting people to draw money out of their pensions earlier and in larger amounts.
INTERVIEWER:
Don't you suppose if you are savvy about it yourself and you do know what you're doing, then it is a good thing?
JONQUIL LOWE:
It is a good thing, yes, up to point. I think what you've got to remember is that when you're planning finances over the long term, you can do everything right, and yet still have a bad outcome. Because there's always uncertainty.
We had the global financial crisis in 2008. There are people going back a bit further, 2000, who saw their pension funds tumble because of the dot com crisis. So just because you've made the sensible decisions, it doesn't mean you're sheltered from risk.
INTERVIEWER:
Finally overall, do you think it's good or bad for the country? Maybe that's an important little question to ask you.
JONQUIL LOWE:
I'd like to sit on the fence on that one because I think the pensions changes are so radical. I'm really worried that 20 years down the line, we're going to have two tier pensioners-- those with the good, defined benefit schemes having a regular income, good pension, and those who've got small pots or have frittered away their pension early in retirement and are actually having to eke out very poor living.
So I just don't know. We'll have to see. The verdict's out on that one.
INTERVIEWER:
Well Jonquil Lowe, thank you very much for your time. It's been a pleasure.
JONQUIL LOWE:
Thank you.
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