OUR GUIDE TO PENSION LIFESTYLING
Pension lifestyling aims to gradually reduce risks in your pension investments as you approach retirement age, and is a common feature of most pension schemes. You should read this article if you are 10 years away from your pension scheme retirement age (most likely if you are aged 50-55, or older).
This article explains why pension lifestyling is not fit for gradual retirement via flexible pensions. We explore why you should consider an alternative approach, especially if you plan to retire early, or access your pension flexibly.
- What is pension lifestyling?
- How does pension lifestyling work in practice?
- Which schemes use pension lifestyling?
- When does pension lifestyling work well?
- When should you avoid pension lifestyling?
- Reviewing what you want in retirement
What is pension lifestyling?
Pension lifestyling aims to reduce the risks you take with your pension funds as you approach retirement age. The aim is to preserve the purchasing power of your pension funds so that you are not penalised by unexpected stock market falls just before you retire. This is sensible if you plan to buy a pension annuity, but not if you want to use flexible pensions.
In general, the more risk you are prepared to take with your pension funds, the greater returns you can expect, on average over time. The reverse tends to be true: if you take less risk with your money, you should expect lower returns. Always remember that there are no guarantees with investing money.
Savings in pension schemes tend to be made over a very long period. Your working life can be more than 40 years, and the life of your pension savings can be until the day you die, so feasibly your pension scheme could run for 30 years after your retirement from work. For this reason, it is generally good practice to use shares in your pension investments, as this should lead to greater investment growth over time. The downside is that shares can be volatile (their value shifts up and down rapidly).
The purpose of a pension plan is to provide you with an income in later life. If your pension fund falls in value just before you retire, your income may reduce in later life. Pension lifestyling aims to reduce this risk.
This example shows the risk that pension lifestyling aims to solve. Your fund tends to grow over time (the green line). In practice, the fund value will fluctuate, and would not progress in a linear way like in the example. Ideally, you would take your income from the fund at retirement with continued growth (the purple line). If your fund drops in value just before you retire (the red line), then you risk taking less income from your pension fund. If you want a guaranteed income for life, then you will lock in this loss permanently.
How does pension lifestyling work in practice?
Each scheme approaches pension lifestyling in a different way. In general, the idea is to gradually reduce the risks of your investment portfolio as you approach your retirement age. The standard way to do this would be to gradually shift your investments from higher risk funds to lower risk funds, at set intervals. Pension lifestyling might look something like this:
In this case, your pension fund would gradually shift from higher risk to lower risk, so that the day before you retire from the pension scheme, you are sure that your fund value would not go down in value. This allows you to retain the purchasing power of your pension plan.
Many pension schemes also offer special retirement funds, which are designed to preserve your capital before you make decisions with your money.
Which pension schemes use pension lifestyling?
Pension lifestyling applies to money purchase pension schemes. These pension schemes allow you, and your employer, to save money from your salary into a fund that will accumulate over time in a tax-efficient scheme. The idea is that you build a pot of money over your working life, which can be converted into an income to fund your retirement. If you have a pot of money that goes up and down in value each year, you have a money purchase pension. With money purchase pensions you take the risks with the savings. If the pot of money grows, you will have more money from which you can take an income; if it falls in value, then your income will be smaller.
Pension lifestyling does not apply to you if you have a final salary pension, since your pension scheme will take the risk, and therefore promise a guaranteed income for life in retirement. This guarantee is why final salary pension schemes are so valuable to members, and why you should be very cautious about moving away from these benefits. If your employer sends you a statement each year to tell you how much your guaranteed income will be in retirement, then you have a final salary pension.
When does pension lifestyling work well?
Pension lifestyling is a great solution for you if you want to buy a guaranteed income for life (called a retirement annuity). Typically, if you buy a retirement annuity, you swap your pension fund for a fixed income. The income paid will depend on a range of factors such as your age, health, lifestyle, and importantly the value of your pension fund. If your pension fund falls in value just before you retire, then you will lock in this drop in value for the rest of your life. This is what pension lifestyling aims to avoid.
Let’s revisit our earlier example.
The chart above shows the real effect on your retirement income, using some simple assumptions. For the purposes of this article we have assumed that you can get a guaranteed income from your pension annuity of 5% per year, although this will vary in practice according to the market rates, and your personal circumstances.
Based on these assumptions, if your pension fund value grows from £100,000 to £120,000, then your pension annuity will be £6,000 per year (the purple line).
If your pension fund value falls from £100,000 to £80,000, then your pension annuity will be £4,000 per year (the red line).
The difference can be dramatic, and unfortunately you will lock in these income reductions for the rest of your life. Pension lifestyling avoids this problem, but only if you plan to buy a pension annuity.
When should you avoid pension lifestyling?
You are retiring early, or late
Pension lifestyling works well if you plan to retire at the retirement date you set when you started your scheme, and if you plan to buy a pension annuity. How likely is this in your case?
Many retirement schemes use dates that are set by your employer, and not by you. Just because someone else decided that you should retire at age 60, or age 65, doesn’t mean that this fits your circumstances. Also, the state pension is rarely aligned with other pension scheme retirement dates.
- If you retire early
Pension lifestyling might not have fully reduced the risks in your pension funds, which would still leave you open to falls in your pension fund (although not as great as would have otherwise been the case). The earlier you retire, the more you put your fund at risk of falling just before you take your pension income;
- If you retire late
Pension lifestyling might have completed, but you might suffer from years of reduced investment growth while you make your decision to retire from the scheme. This could have an effect on your eventual retirement income if investments would have grown during that period. The longer the period with no investment growth, the further behind your income could fall.
You want a flexible retirement (drawdown)
Many people now use flexible pensions to build a retirement that works for them, rather than being tied to a traditional fixed income. Flexible pensions work well in conjunction with other sources of guaranteed income, like retirement annuities, final salary pensions, and the state pension. You can choose when you take your income, how much you take, and can pass on the value of the fund to your family if you die before your pension scheme is exhausted. The downside is that these schemes need greater management, and carry risk and charges for your money.
Case study – flexible retirement in practice
Many people use flexible pensions to bridge a gap in their income while they gradually retire on their terms.
Let’s examine a case study of how this might work in practice. Jenny is approaching age 60. She wants to achieve an income from all sources of £30,000 per year. She wants to gradually retire from her current work as a freelancer, but she wants to balance her work commitments over the next few years, so that she works on her terms. She will receive her state pension at age 66, worth £7,500 per year. Her former employer’s final salary pension pays her £6,000 per year from age 65. She plans to earn less from her work over a few years, and will reduce her earnings from £30,000 per year now, to £7,500 by the time she is aged 64.
You can see from this example, how the traditional pension annuity would not fit Jenny’s lifestyle and income plans, since she does not want the same income each year from her pensions. She needs a different level of income at each stage of her gradual retirement from work, but this needs to change according to her needs. A pension annuity would probably not suit her needs as much as taking flexible income from her pension plan.
Here is a simplified version of Jenny’s proposed solution:
Jenny needs to add to her income from her flexible pension plan to top up her self-employed income (the blue in our chart). The additional income from her pension plan is shown by the orange in our chart. This needs to change as her self-employed income reduces, and she starts to receive a guaranteed income from her other sources.
Flexible pensions and lifestyling
If you plan to use flexible pensions, you need to change your perspective on the term of your pension investment.
- Pension annuity term
The end date for your pension will be when you expect to enter into a pension annuity. This is the date you swap your pension fund for the pension annuity. If you want a guaranteed income, the concept of pension lifestyling works (assuming you time the reduction in risk correctly);
- Flexible pensions term
The end date for your pensions will be completely different with flexible pensions. The investment term could conceivably be for the rest of your life – potentially greater than 20 years past the traditional scheme retirement date.
If you want to use flexible pensions, then the concept of pension lifestyling no longer works. Why would you want to reduce risk to nil in your pension portfolio, if you want the money to last as long as possible? You should aim to maintain an appropriate level of risk to enable you to extend the income paid under the pension scheme. Only when you want to move to a pension annuity, or if you have another reason to reduce risk, would you take risk off the table. If you enter flexible pensions, you should probably maintain a high risk level in your portfolio, with the aim of increasing the total income available from your pension plan.
Reviewing what you want in retirement
Unfortunately, many pension schemes are set up as if there is one solution that works for everyone, which is why they set up pension lifestyling. If you are approaching the age when you might consider accessing your retirement savings (over 50), then you should review how your pension investments are structured. Not only will this give you an idea of the potential income available to you, but also how you might be able to take this income in the future.
Action to take:
- Examine each pension scheme to see if pension lifestyling will apply
- Find out how your pension investments will change, and over what period
- Consider how you might want to take your income in retirement
- Adjust your investment strategy to match your pension income goals
How we help with retirement
We can help you to plan a balanced retirement, which ensures that you have security in your future, a decent lifestyle, but allows you to retain meaning and purpose. This starts by analysing your existing pension plans, and helping you to build a plan for the changes you see coming in the future. We explain more in our Retirement pages.
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About Dan Woodruff
Certified Financial Planner & Chartered Wealth Manager at Woodruff Financial Planning
Financial Planning helps you to navigate and anticipate significant life changes. I want to help you to ensure your money is managed wisely to give you the financial security that will fund the future and lifestyle that is important to you.