Europe Hammers UK Pensioners

Kids Fighting

The political wrangling over the Euro fiasco continues with the main protagonists slinging mud and calling each other names like spoilt school kids but what does all this have to do with UK pensioners?  Well, this one is a bit left-field but bear with me and I will try to explain.

Anyone about to purchase an annuity with their pension fund may be in for a nasty surprise. Annuity rates (the rate at which pension funds are converted into retirement income) are currently at an all-time low. This means that every pound in your pension fund buys less retirement income than it would have done in the past.

The same is also true for anyone about to enter Income Drawdown, or for anyone already in Income Drawdown who is about to have their maximum withdrawal limits reviewed. A number of factors have conspired together to create a “perfect storm” which in some cases will cut pensioners maximum income in half. Yes, that is correct, if you are currently drawing an income of say £30,000 per annum from an income drawdown plan and this is due to be reviewed in the foreseeable future you may find the Government reduces this to only £15,000.

How can this be and what has it got to do with President Sarkozy and Chancellor Merkel?

The maximum amount an individual can withdraw from their pension fund (known as Income Drawdown, Pension Fund Withdrawal, Unsecured Pension or, since April this year, Capped Drawdown) is determined by a formula based on GAD tables (Government Actuaries Department). The calculation considers a number of variables including age, gender and long-term interest rates. The tables were reviewed recently and new tables came into force in June this year. The new tables are generally less generous than those they replaced. A major reason for this is that they have been amended to take account of improved life expectancy. Your Income Drawdown pension fund is expected to need to last a lifetime. Therefore, if the sum of money in the pot remains unchanged but the lifetime becomes longer, money must be taken out more slowly.

If this was the only change, pensioners in drawdown would have seen a drop of up to 10% in income. However, prior to April the maximum an individual could withdraw was 120% of the figure derived from the GAD tables . In April this was reduced to 100% – on top of the fact that the tables themselves have been reduced. This means that, all other things being equal, pensioners could have expected a fall in income of around 20%. Unfortunately, all other things are not equal.

The final variable used in determining maximum annual income is long-term interest rates. The particular long-term interest rate that matters when assessing maximum income withdrawal is the yield on 15 year UK government bonds (also known as 15 year gilts). Whilst rates have generally fallen in recent years, the crisis of the Eurozone has exacerbated the problem and they have plummeted recently as can be seen from the graph below.

gilt yields-pi-201_800x600x0

Bonds are loans to governments. Gilts are loans to the UK Government.  These bonds are issued with a fixed rate of interest for the term of the loan. However, bonds can be traded during their term in much the same way as shares. As the interest is fixed in money terms, the interest rate (yield) to anyone buying an existing bond falls as the price of buying the bond rises. On the other hand the interest rises as the price falls.

You may have noticed news coverage about the cost of government borrowing increasing in some European countries, most notably Greece and Italy but even France and Germany have not been immune. This is because investors making loans to these governments are worried about the prospects of receiving their interest payments, or even receiving the return of the initial loan in future. It is entirely possible the borrower may default on some or all of its obligation. However, these investors such as pension schemes and cash rich countries like China have to put their money somewhere and at the moment they see the UK as a safe haven relative to other options open to them. Therefore, investors are paying well over the odds for UK gilts, which has significantly reduced the yield to investors (remember the interest payments from a gilt are fixed at outset so as the price increases in the marketplace the return to the investor buying the gilt reduces).

When the concept of withdrawing income from your pensions pot was introduced in 1995 (it was called Income Drawdown at the time) Gilt yields were around 9%  but had been as high as 12.84% in April 1990 .  At the time Income Drawdown was seen as a means of allowing pensioners to delay the purchase of an annuity until interest rates improved. From the introduction of Income Drawdown, the Gilt yields fell steadily to around 6% in 1998 (when the data for our graph starts) and have dropped even further since – as of today that figure is 2.5%!

If investors were not so worried about European government’s ability to repay their debts UK pensioners may not find their retirement income squeezed quite so much.

To put this into perspective it may be helpful to look at a worked example.

John retired five years ago on his 60th birthday with a residual pension pot after drawing his tax free lump sum of £500,000. At the time 15 year gilt yields were 4.5%. Based on this the GAD tables in force at the time this allowed him to withdraw £64 for every £1,000 in his fund and then multiply the answer by 120%. For the last five years he has been withdrawing the maximum amount allowable of £38,400 each year from his pension fund. However, the rules state that the pension company providing his income drawdown policy must review the maximum withdrawal on the fifth anniversary (in future this will be reduced to 3 yearly intervals).

John is now 65 years old and has now withdrawn a total of £192,000 from his pension fund (£38,400 x 5 years). As a result of a combination of high withdrawals and lower than expected investment returns, John’s pension fund is now valued at just £350,000. Based on the new GAD tables, a 65-year-old is allowed to withdraw £58 per £1,000 of fund value.

Remember from April this year he is no longer able to multiply this by 120%. Therefore, from next month onwards, John’s income will be reduced to £20,300 pounds per annum – a fall of almost 50%.

Some people may be able to avoid this restriction if they are able to show that they qualify for the new “Flexible Drawdown” option that was introduced in April of this year. Where an individual can show that they have at least £20,000 of guaranteed pension income in the tax year, they are able to switch to Flexible Drawdown and avoid the limit entirely. In fact they can withdraw the entire value of their pension fund as a lump sum if they so wish, but such a large withdrawal is likely to be subject to tax at 50% on a large portion of the fund. The real attraction is not so much the ability to withdraw the entire fund but the ability to have complete flexibility over the amounts withdrawn each year without the need to assess these against the standard capped drawdown limits. However, it is important to remember that taking money out of the fund at an accelerated rate greatly increases the risk of running out of money during your lifetime.

So, in a nutshell, we can see that UK pensioners’ in Income Drawdown, or buying an annuity, have had their retirement income slashed and it’s all the fault of those crazy Europeans. There is absolutely nothing xenophobic about this newsletter, honest!!!

Forty Two – December 2011