Protect your future self’s wealth from a pension time bomb

Unlike in the 1989 film Back to the Future Part II, starring Thomas F Wilson as young and old Biff, those in retirement will not be able to travel back in time to help their younger selves with money worries.

As new rules lower final retirement pot forecasts, Eithne Dunne asks how you can maximise the power of your savings.

Should a benefit statement for your pension arrive in your letterbox over the next few months and you compare it with your previous one you might be a tad taken aback. Pensions have broadly recovered from the shocks of early last year. The projections for your final retirement pot and the income it will support will be lower, and in some cases considerably so.

First, don’t panic; these amounts are, at the best of times, educated guesses, and your statement will stress that the figures are estimates, and not a reliable guide to the future performance of your investment. Nevertheless, in the absence of any other guide pension holders will take notice and may well be concerned.

So what has changed?
The Society of Actuaries in Ireland introduced guidance in March that obliges pension providers to calculate their projections in a much more conservative way. So whereas up to now they were able to assume a certain level of future growth for various types of investment/asset classes each year, they must now assume a lower level of growth.

“Historically, actuaries looked back at asset performance in previous years and used this as a guide to future performance,” says Glenn Gaughran, head of business development and marketing at Independent Trustee Company (ITC). “However, as the world is changing so quickly, such a methodology has become unreliable, hence the need to take a more prudent approach.”

For example, the assumed growth of equities and property was previously a maximum of 5 per cent; it’s now limited to 4.5 per cent. The maximum growth assumption allowed for bonds has fallen from 2.5 per cent to 1 per cent, and for cash from 1 per cent to 0 per cent. Pension providers must also rein in their estimates of future salary growth, which also feeds into these pension pot projections, from 2.5 per cent to 1.5 per cent.

Note that these new growth rates are the maximum allowed. Some will be even more conservative in their calculations. ITC, for example, has turned its future growth rates for cash to negative (-0.65 per cent) where a pension holder has fewer than five years to retirement.

What does it mean for me?
Projections depend on how your money is invested and how long you have until retirement. Generally, the younger you are, the bigger the drop. But it’s also about how your pension is invested.

As mentioned, the forecasts for property and equities have been downgraded only slightly, in stark contrast to traditionally lower-risk investments such as bonds and cash.

Take the example of one PRSA holder (an ITC client) who is six years from retirement, and who has invested in a mix of assets including property and cash, and has stopped contributing. In March 2017 their pot was valued at €270,526. According to the benefit statement from the time, and with ten years to retirement, the projected value, including expected costs and the growth rates that applied back then, was €395,437.

Now the same person’s pension value is €264,822, and the comparable projected value at retirement is €334,899, a drop of about 18 per cent of the expected fund value in four years.

What should I do?
First, Mark Reilly, the pensions proposition lead at Royal London, stresses that the projections that appear on your statement are meant purely as guidelines. “They don’t change anything with regard to the value of your fund today.”

However, he says that if you are concerned about the reduced estimates, speak to your adviser about increasing your contributions, consolidating pensions, if you have several, or reviewing your asset split.

“Many people choose to leave a lot of their fund in cash or bonds, believing these will eliminate much of the risk, but the fact that the growth projection rate for these has been cut to 0 per cent emphasises the weakness of such a strategy,” he says. “If we are hit by material inflation over the next couple of years, this would effectively result in the real value of a fund going backwards.” According to Gaughran, some pension holders had already been taking steps away from cash and bonds.

“The negative returns expected in cash and historically low bond yields appear to have driven greater interest in diversifying to other asset classes such as property,” he says. “We have seen self-directed pension savers looking for greater control and investing in assets they have more knowledge of, particularly with property that earns a rental yield.”

Patrick McGettigan, director at McGettigan Financial Planning, is unequivocal about the importance of minimising bonds and cash — unless you are close to retirement. “Historically, a well-diversified equity portfolio has been the best home for a long-term investment,” he says. “I would argue that, right up to five years to drawdown, a portfolio should be split 80:20 equities to bonds/cash.”

He says that for anyone uncomfortable with the volatility of equities, it’s worth remembering March last year when global equity markets dropped by more than 30 per cent with the outbreak of Covid-19. “Those who reacted and moved to cash crystallised that decline; those who did nothing have made it — and more — back since.”

Niall Rooney, financial planning manager at City Life Galway, recommends that when you get to within five years of retirement you switch 25 per cent of your pot (the amount you’re allowed to take as a tax-free lump sum) into a conservative or cash fund, leaving the rest in a “more aggressive diversified fund”.

He says it’s a strategy likely to suit many pension holders because there is a strong possibility they will reinvest whatever is left after taking their lump sum in an approved retirement fund (ARF) after retirement, thereby ensuring exposure to risk assets over the medium to long-term.

In an ARF the retiree is obliged to draw down income of 4 per cent a year. Rooney recommends that you or your adviser designate a specific conservative fund, equivalent to 12 per cent of your ARF, to generate the initial three years of the compulsory drawdown. This reduces sequencing risk, or the impact of different investments yielding returns at different times. It allows time to invest a bit more aggressively with the remainder of the funds.

Annuity v ARF
When looking at the new lower projections, bear in mind that it is becoming increasingly common for retirees not to take their pension in the form of annuities, but instead to take their 25 per cent tax-free lump sum and leave the rest invested via an ARF. This changes the picture, because it means that your money can continue to grow after you retire, therefore potentially providing higher income than the figures on your benefit statement might suggest.

While this option by definition carries a bit more risk, says Reilly, it gives you greater control than the annuity route, as well as the potential for higher income. It also means you have an asset that can later be passed on to a spouse after your death, for example.

In contrast, as McGettigan notes, an annuity will generally only start recouping its value when the pension holder is in their eighties, with “all or some of the benefit typically dying with you”.

According to Rooney, large numbers of pension holders now prefer the ARF route for various reasons. “It may bring enhanced returns but it also gives much greater income flexibility, taxation control and, most importantly, it secures the remainder of the fund for your estate.”

One likely, albeit unintentional, consequence of the new rules will be that they will spur at least some pension holders to take a more active role in directing their pension.

If you are reviewing your pension or planning to meet with your adviser, he says the three main things to focus on are: getting as close to the maximum tax-free contribution as you possibly can; ensuring that if you’re more than five years from retirement, your portfolio is heavily weighted towards global equities; and then sticking to the plan, without reacting to either benefit statements or the markets.