How to buy a pension

Buying your pension is one if not the biggest financial decisions you will take (or have taken). It’s fearfully difficult and most people take it with little help and – worse-information. Almost everyone is going to have to do it and that so few know how …is scary.

Ask most people to explain why they bought the pension they did and they will look blankly at you and say things like “because I had to” or “I got a letter from my pension people telling me what I was going to get”. PICA, an organisation set up to improve the standard of “at retirement advice” reckons that up to 70% of annuities bought in the UK in 2010 were bought without shopping around.

The ignorance is not confined to class, creed, gender or income bracket– it’s a general social malfunction!

I hope this article will be generally helpful but it was prompted by my particular friend Mark. He is a very clever and successful man but has no idea about pensions . He uses ISAs rather than pensions because he understands ISAs and doesn’t understand pensions. My challenge is to help him understand pensions.

That Mark feels he needs to take advice should be taken as black mark for the pensions industry. Ideally people should be able to retire without the stress of all the decisions I’ll be talking about. When most pensions were paid by an employer as a defined benefit – a set proportion of salary, none of this mattered – the decisions were taken for them.

We’ve taken  the certainty out but left  the complexity in.

The days of pension certainty appear gone but  pension people haven’t adjusted to the new world where non-pension people  have to take hard choices .The support mechanisms are not in place and that’s more the fault of pension advisers than their customers.

To sum up Mark’s frustration;-

He needs to take advice on these decisions and that’s not good. Worse – there’s not much advice about. 

I don’t blame people like Mark who would rather invest in something they understand than something which might be better but doesn’t come with a “handbook or a help line”.

 This article doesn’t solve Mark’s problem but perhaps it will help him (and you) understand what pensions are, why we have to buy them with our pension savings and the sort of decisions you need to be taking when you come to buy your pension.

The Big Idea.

The people who really understand pensions are actuaries. They get the big idea but they have difficulty passing it on. Let’s step into actuarial shoes for a few minutes.

An accountant tells you what has happened but an actuary guesses what will happen.

Both use data but actuaries use data creatively to help people plan for the future.

If an actuary looks at retirement, he (or she) sees it as a series of bars that could look like this.

I just found this picture and the numbers don’t relate to anything or anybody – they’re random.

You could give this picture to a class of schoolkids and ask them to invent a story about why this person needed nearly £800,000 one year, why his needs for cash grew from the start of the graph (call it “when he retired”) fell away, and then ended.

Most people would guess that the cliff edge on the right meant “death” and might reckon that as the person closed in on death he spent less and that his spending needs increased from the early years to a point when he needed an awful amount of money in the midst of his retirement (perhaps he needed to buy a retirement home-perhaps he pre-paid for his nursing home).

This is the big idea for an actuary’s. An actuary will try to predict the cash flows he will need for each of the years (possibly every month) of the rest of his life and will try to make sure that not only has he got the cash to pay the early cash calls but also the last one. He will try to predict the date he dies. He will try to predict inflation and he will try to predict the real rate of return on his investments (how much they grow faster than inflation).

The number he comes up with, is the amount needed to secure these future cash flows. It is a simple number , only a guess, but the output from a lot of calculations!

And this number would be a selfish view, he may also be planning for his wife, he may assume she out lives him in which case he may be planning cash flows for her after he dies. He may even be building in a contingency for his children so they have an income till they are able to stand on their own two feet.

The big challenge for the actuary, when he’s added up the cost of these obligations,  is to show how much cash he’d need at the start of the period to pay out the cash calls on time and in full. We call  this the cost of purchasing the pension and it’s why this kind of pension saving is sometimes called “money purchase“.

To get his number he needs to build in some assumptions. An assumption on how long he needs money to be paid,  a model of the shape of the payments (like the one above) , a decision on the rate of return he can get on his investments without taking too much risk and finally a definition of what to him is an acceptable level of risk,

The example I have chosen is extreme. Nobody knows with that much detail what will happen to them (though an accountant could plot this chart retrospectively) , even an actuary would look at such a detailed prediction and mutter  words like “spurious and speculative”.

The actuary will try to simplify matters and show a few simple choices he has to make. These choices that he’d ask himself might be

“do I need an income that is protected against inflation”

“do I need to leave money for others or can my pension die with me”

“am I happy to accept that if I die after a couple of months, someone makes a lot of money or do I want a guaranteed pay-out, if only to see justice done!”

In taking these decisions he will consider all kinds of things – the likelihood of him receiving income from work he does, or capital from inheritances. Hell ask himself whether there are assets he owns which he could realise if the income ran out… and so on.

He might conclude that because he was prepared to live with the consequences, he was ready to take some investment risk and accept that the money might run out, or quite a lot of investment risk and take a bigger chance. The actuary would work out what the chances were that his pension ran out (went bust ) and then he might ask – what then? Could I live with the consequences. This is sometimes known as a Value at Risk calculation (shortened to VAR).

You’d think that in a free society  most people would like to make choices about what level of risk they could take but in practice , you probably won’t get that choice. The authorities in the UK are terrified that your pension will run out and leave you destitute in your last years. Many experts think this is overly protective and want the Government to allow other approaches. They reckon that  when risk’s  shared between the pension provider and the pensioner you get  better overall outcomes. If you read about pension “risk sharing”, this is what’s being discussed.

 In practice you’ll be buying a pension guaranteed by the insurance company you buy it from. You pay for that guarantee whether you want to or not. If you read my blogs on “guarantees and certainty“, you’ll know that I think we don’t need these guarantees and would be better off like the Dutch – who trade certainty for a better income… and live with the result.

Back to the actuary now…

It was only when he’d come to conclusions about his life expectancy, the amount and shape of his future financial requirements, his obligations to others, the degree of risk he was prepared to take of not being sure things would work out and last but not least, the affordability of his plan, that he would look to set up his pension.

If he was an actuary with a lot of time on his hands, he could of course manage the money himself and this is what some people attempt to do (this is known as income drawdown and is a process where money is drawn from a pot according to need each year with the hope that the pot doesn’t run out). It is very flexible but it’s time-consuming and risky (as it requires many manual interventions). Frankly, unless we are talking about future cash flows (let’s call them liabilities from now on) of more than £400k, income drawdown’s unlikely to be worth it.

To put it in today’s terms, to meet £400k of future liabilities at 65 , you’ll need a pot of money of at least £250,000.

Income drawdown rarely works unless you have a quarter of a million pounds worth of pension savings or  you are lucky enough not to need a retirement income.

As an alternative to the drawdown approach, the actuary might consider purchasing an annuity from an insurance company which will promise to pay him a pre-agreed amount on a regular basis from day one till death do you part. The shape of these payments can be increasing or level, the increases can be fixed or linked to a notional index like RPI or CPI, there can be guarantees built in that a capital sum of up to five or even ten years could be paid if you died early and you might even like to build in insurances against desperate liabilities like the cost of dementia care for you, your spouse or the both of you.

Every decision would be, for the actuary, decided upon after a cost/benefit analysis and the decision would be taken with regard to the likelihood of the financial need arising.

Because everyone has a different view – you’d be mad not to get a variety of quotes from different annuity providers and take the one that best suited you. Why should purchasing a pension be any different from buying a car or a house or a wooden floor. You wouldn’t take the first offer on anything else. As Martyn Lewis says 

“the first rule is to shop around!”

Now I’ve spelt all this out in the hope that you can begin to understand that the choice you make when you decide to cash in your pension savings and buy an annuity is a tricky choice. Deciding the likelihood of all these things happening needs good quality information which you need to get hold of. It would be absolute folly to try to work out how long you were going to live without reference to your state of health. You would be well advised at the very least to have a medical check up and you’d probably be thinking about how long your parents lived and their parents before them. Actuaries can make more detailed guesses, they look at where you live and can take even more accurate guesses from your lifestyle choices. If they were given your Tesco Clubcard, they could probably take decisions based on the type of food you bought!

The point of doing this research is not just to help you plan, it’s to help you get the best rate. If you can convince someone that you are likely to die in fifteen years, he will pay you a better pension than for the average person of your age who he assumes will live 20 years.

Of course sex (gender) comes into it but because we are good EU citizens , we have to assume that in future males and females will live the same age (or we will discriminate against woman who historically live longer). But I digress…

Buying an annuity is a) important b)difficult and c)misunderstood. 500,000 people will buy annuities of “pensions” this year and most of us will get the wrong shape and not get the best rate for our health and all who buy this year will buy into an expected investment return artificially depressed by quantitative easing which has so depressed the rates of return on the annuity investment that you might as well be investing in the mattress you sleep on.

But that’s a temporary thing. Hopefully most people who are reading this purchased their annuity when rates are better, aren’t needing to buy just yet or do need to buy but have found a way of putting the purchase off. The trouble is that the people who’ve read nearly 2000 words so far are the kind of people who like to be expert and are all too likely to be ….actuaries…..and probably have their pension guaranteed by the Government or a strong employer!

Am I wrong?

About henry tapper

Founder of the Pension PlayPen,, partner of Stella, father of Olly . I am the Pension Plowman
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6 Responses to How to buy a pension

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  2. Oh dear, having read through the 1,500 words the last few are telling – I’ve only bothered to do so because it’s my area of interetst!

    That does sum up the problem very neatly indeed. Unfortunately I think RDR removing commision may well be a negative factor here. While a top % (usually those in the drawdown category) can afford to pay fees to get best advice from an actuary or advisor on their annuity/pension the majority cannot. They are then left with general ‘guidance’ which is likely to add more confusion and lead to bad choices. I am of the opinion that there is nothing inherantly bad about commission – as long as there is transparency. After all, who would object to an adviser taking say £500 on a one-off for finding an extra £150 per year on their annuity?

    It is a real shame that people are being turned off pensions, the bottom line is that there is no more efficient way to build up retirement capital.

  3. henry tapper says:

    A good point Thornton. I agree that advice is needed (though I wish it weren’t) and if advice is neeeded, it needs to be paid for.

    There may be an argument for this being an employee benefit (eg part of the organsiation’s pension spend) your argument hgolds good either way, the cost of getting it wrong outweighs advisory fees.

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