Hello, and welcome to the third in our series of Insightful Planning with Astute videos. I’m Elliot Unsworth, Head of Client Proposition at Astute Private Wealth, and in today’s video, we’re going to explore cash flow forecasting and dive into the intricate world of retirement income planning.
Whilst a pension is just one of the many vehicles that may be available to you once you decide to stop work and may just make up one part of your overall resource, for the purposes of this video, we are going to focus solely on pension planning and how a pension can be used to provide an income in retirement.
So, let’s get started.
As we navigate these waters, we’ll focus on two commonly used pension income strategies: annuity and drawdown. An annuity typically offers a guaranteed income stream for life, providing financial security but often with less flexibility. On the other hand, drawdown typically allows more control over how you access your pension fund but involves managing the longevity of your assets.
Let’s understand the implications of these choices. Annuities typically provide a predictable income that is secure for life, but they won’t suit everyone due to the lack of flexibility. Drawdown allows for more personalisation, aligning with varying lifestyle preferences and financial goals, but comes with the very real risk that you may run out of capital, and therefore income, in your lifetime. Furthermore, drawdown allows for your pension to remain invested and is therefore subject to market movements.
Let’s have a look at some cashflow outputs so we can begin to see the difference between these 2 pension income options. Firstly, let me introduce our client, Sarah, who has retired aged 60 with a pension fund worth £500,000. For the moment, let’s ignore any other assets that Sarah has and ignore Sarah’s expenditure. Instead, we’ll look at the capital that is available to Sarah at any given moment, over time.
In scenario 1, Sarah starts off with £500,000 in her pension, illustrated by the green bar. She purchases an annuity: essentially, she swaps all of the pension fund in exchange for a regular income for life. As I said earlier, we aren’t looking at expenditure yet, so the income builds up over time in savings, as demonstrated by the pink bars. This chart is purely to show the value of the annuity over time. By the time Sarah reaches age 100, the annuity will have paid out just over £1.8million.
In scenario 2, Sarah retains her pension fund, which continues to grow over time; you can see that the capital value of her pension fund surpasses £2 million at age 100. On the face of it, Sarah would get more value out of retaining her pension fund; however, this is far from the whole story.
Now let’s revisit these scenarios and look at the income being generated and, therefore, how much Sarah can afford to spend each year. With the annuity, you can see the regular, guaranteed lifelong income being paid each year, in green. The annuity is predictable, and the answer to the question “how much can Sarah afford to spend?” is easy; she can spend the income, which is around £24,000 p.a. in this example. The annuity will payout for the remainder of Sarah’s life, so during her lifetime, there are no unknowns and no variables with this annuity; its main benefit is its security.
Now we can have a look at the income generated in the drawdown scenario. This might look like an error, but this is because the income amount is undefined; Sarah can draw whatever she likes whenever she likes. She could even withdraw the whole pot on day one; spoiler alert – this would not be a good idea for many reasons.
Instead, we can use the cashflow tool to calculate a “sustainable” income, with the aim of providing a comfortable retirement without exhausting the pot too early. Here you can see that the drawdown pension fund is depleted at age 100, which is the intention for the time being. Based on a number of assumptions, such as investment growth of 4.5%, inflation of 3% and life expectancy of 100, the calculated sustainable income is £17,000 p.a., which is considerably lower than in our annuity position.
So, on the surface, the drawdown route provides less income and is riskier; why would anyone opt for the drawdown route?
The key is in the flexibility that drawdown can offer, and the ability to shape the income you draw over time to reflect your changing circumstances. There are a few key changes that we can account for next: the introduction of a State Pension entitlement and a reasonable reduction in the costs of living in old age.
Back to our annuity scenario, the change we have made this time is to add Sarah’s State Pension entitlement at age 67, granting her an assumed additional income of £11,500 p.a., shown in blue. You can see the marked step up in her available income at that time. Again, the answer to the question of what can be spent is easy, except now it’s £24,000 p.a. until 67, and then £35,500 p.a. thereafter in today’s terms.
What you will note here is that Sarah’s full income continues into old age and all the way to age 100. In fact, not only does it continue, but it actually increases; she’s earning the most in her retirement at age 100. Now, it would be nice to think that we could continue going on holiday, eating out with friends and regularly visiting the gym into old age, but we often see a marked reduction in spending in later life as the time may come when the mind is willing, but the body is unable.
The lack of flexibility in an annuity means that you will continue to be paid an income into old age, whether you can spend it or not.
Here is where drawdown really comes into its own. In this scenario, we have started with the previous “sustainable” income of £17,000 p.a., but when Sarah’s State Pension comes into play, she is able to reduce her drawdown pension income by the same amount, so that her total income is unchanged at this point. This means that Sarah is expected to reduce her reliance on her pension fund in later life. You can see here that the change to the value of the pension fund over time is astounding; now Sarah is predicted to have over £1.5 million in her pension at age 100.
Instead, Sarah has the opportunity to increase her income in early retirement, with a view to reducing it in later life. Our final scenario here shows Sarah drawing an income of £30,000 p.a. initially, reducing her income when her State Pension becomes payable, such that her total income stays the same, and then reducing her income again in later life. This has been done with the aim of her capital just about lasting to age 100, as you can see here.
This much more realistic picture shows that Sarah can have a more luxurious lifestyle in her younger years, Sarah and her husband can enjoy the holidays they both had dreamed of, with the very realistic expectation that her lifestyle will mean reduced spending in later life. This kind of flexibility simply is not available with an annuity.
As we compare the two scenarios, it’s crucial to balance the desire for early enjoyment with the need for financial security later in life. Our detailed projections empower you to make informed decisions that align with your retirement goals.
When assessing which option is right for you, the ‘income security of an annuity’ versus ‘flexibility of drawdown’ debate is just one consideration. There are inheritance considerations and tax planning strategies that will need to be built into a retirement income plan, potentially long-term care costs, such as care fees, to name a few, and it requires a detailed and holistic view of your personal circumstances and objectives in order to make the right choices for you.
Understanding these scenarios helps us create a personalised retirement income strategy tailored to Sarah’s preferences and financial objectives. Our powerful forecasting capabilities ensure we can navigate the complexities of retirement planning with improved clarity and confidence.
Thanks for joining me in this exploration of pension fund withdrawal options with cashflow forecasting. If you have questions or want to discuss your specific retirement plan, don’t hesitate to get in touch. Stay tuned for more insights, and until next time!
