How best to plan to use some of a (currently 100% equity) DC for an annuity in six years time?

ukdw

I think a plan based on taking an annuity in a certain number of years time is pretty tricky as rates could revert back to poor.  Also if you lower the potential growth of the funds intended to purchase that annuity you could also lose a large amount of growth potential too.

Personally I would leave the funds invested until at least age 57, and then put off the decision about annuities until then.

Then at the time I would only buy an annuity if the balance between fund growth and annuity rates is good - if not I would still retire, but hold off on any annuity purchases until/if the balance between annuity rates and purchase funds improves and even then I would probably only purchase say 50% of your eventual target annuity amount, and then buy the rest later.

LHW99

Just take the money out of your fund and buy the annuity.

To elaborate on this - I don't think you need to actually take money out of the pension. That would be done by the annuity provider and the 25% returned to you by them.

If you actually took the money out of the pension, then it would be like a UFPLS and 75% would be taxable and would trigger the MPAA. Buying the annuity from the pension itself is different because you are taxed on the annuity income.

Yorkie1

DRS1 said:

Yorkie1 said:

It might be worth double checking, if it's relevant, whether using part of a pension pot to take an annuity will trigger the MPAA (and so limiting how much you can put in a future pension).

I don't think taking an annuity triggers the MPAA but taking UFPLS certainly will.

The reason I mentioned it, is if OP was intending to take a fixed term annuity rather than a normal full life annuity (having re-read the thread, I can't now see any specific reference to it).

I understood that a fixed term annuity can trigger the MPAA, but as you say, a standard annuity wouldn't.

OldScientist

ukdw said:

I think a plan based on taking an annuity in a certain number of years time is pretty tricky as rates could revert back to poor.  Also if you lower the potential growth of the funds intended to purchase that annuity you could also lose a large amount of growth potential too.

You can secure current rates by holding fixed income that matches the type (i.e., nominal or inflation linked) and duration of the annuity plus the delay time until purchase. Very roughly, the duration of the annuity is half of the unisex life expectancy (the value depends on yields, low yields gives higher durations and vice versa). For current inflation linked yields (1-2%), the approximation is close enough.

So how does this work? If yields go down, the payout rate of the annuity will also fall, but the value of the fixed income holdings will rise. With perfect matching, the rise in value will match the fall in payout rate and the amount of income secured will be the same as if yields hadn't changed. Of course, perfect matching is unlikely to be achieved in practice, but the tracking error in income obtained will be much smaller than with no duration matching at all.

In your second sentence, you are assuming 'growth funds' will continue to grow. It is quite possible that equity funds will fall by 50% (or more) and, in real terms, take more than 7 years to recover.

BookofShadows

OldScientist said:

You can secure current rates by holding fixed income that matches the type (i.e., nominal or inflation linked) and duration of the annuity plus the delay time until purchase. Very roughly, the duration of the annuity is half of the unisex life expectancy (the value depends on yields, low yields gives higher durations and vice versa). For current inflation linked yields (1-2%), the approximation is close enough.

So how does this work? If yields go down, the payout rate of the annuity will also fall, but the value of the fixed income holdings will rise. With perfect matching, the rise in value will match the fall in payout rate and the amount of income secured will be the same as if yields hadn't changed. Of course, perfect matching is unlikely to be achieved in practice, but the tracking error in income obtained will be much smaller than with no duration matching at all.

In your second sentence, you are assuming 'growth funds' will continue to grow. It is quite possible that equity funds will fall by 50% (or more) and, in real terms, take more than 7 years to recover.

Thanks again for all of the comments - I'm learning (but slowly it seems). 

There's another thread running with a lot of similarities to what I'm after and I've taken a few pointers from that one too.  I think I started with annuity as they now look 'better' value than when I previously discounted that approach when I suppose what I'm really after is a way of locking in some of the value I have in my current 100% equity pot to protect against sequence of returns (partially) during the first 8 to 10 years of accessing the pension which is before my SP and DB income would come online as that is when I'll be drawing most heavily on the pot.  

I have much more inside the pension than outside it - and will address that a little more aggressively once the mortgage is gone in the next couple of years.  But what I'm trying to work out now is how best to start to move away from 100% equity in the pension towards something that will minimise the risk of snatching defeat from the jaws of victory in the next few years.  Swapping some of the existing pot into something else is one way, diverting a chunk of future payments into something non-equity is another.  Either can hopefully deliver a chunk that could buy an annuity or at least be somewhat insulated from an equity correction during that first ten years. 

I have never understood gilts or bonds to a level where I'd feel confident investing, but I've not worried about that as retirement was far enough away that 100% equities felt 'better'.  But now it appears I could (hopefully) be only 70 odd pay packets away from stopping funding the pension and starting to draw from it - I think I need to get a better understanding of my non-equity options. 

I can't access my pension until 57 - but that aligns well with when I think it will be full enough. (and if things went 'very' well in the next 5 or so years there is already enough in the ISA to match at least one years current take home so I could reasonably consider burning through a chunk of that by then if I wanted to stop coming to work before 57) but that means what I do now mostly has to happen inside the pension.

Gilt ladders (collapsing) look interesting, but are they created inside or outside a pension? 

The only gilt related options I can see within my current Aviva pension are BlackRock index linked gilt tracker funds (over 5 and over 15 year versions).  The other 'non-equity' places I could choose to shift to in the pension are a BlackRock Corporate Bond All Stocks Index Tracker or a sterling liquidity fund.  Is there something sensible I could do with those to start protecting against equity drops and prepare for buying an annuity or just drawing from those areas first if / when a crash arrives?  

Sorry, the more I learn the further from a plan I feel - the agony of choices...

Albermarle

Sorry to barge in on the thread, but I have a question, that could also maybe help the OP.

If you have a DC pot and you take all the 25% TFC, leaving only a crystallised pot. You can use this to buy an annuity AFAIK  ( a normal pension type annuity, not a Purchased one ) 
However I am not sure if you can buy an annuity with part of a crystallised pot, or you have to use all of it.
I think in general transferring part crystallised pots generally is not easy/not allowed. I am not sure. 

ukdw

OldScientist said:

ukdw said:

I think a plan based on taking an annuity in a certain number of years time is pretty tricky as rates could revert back to poor.  Also if you lower the potential growth of the funds intended to purchase that annuity you could also lose a large amount of growth potential too.

You can secure current rates by holding fixed income that matches the type (i.e., nominal or inflation linked) and duration of the annuity plus the delay time until purchase. Very roughly, the duration of the annuity is half of the unisex life expectancy (the value depends on yields, low yields gives higher durations and vice versa). For current inflation linked yields (1-2%), the approximation is close enough.

So how does this work? If yields go down, the payout rate of the annuity will also fall, but the value of the fixed income holdings will rise. With perfect matching, the rise in value will match the fall in payout rate and the amount of income secured will be the same as if yields hadn't changed. Of course, perfect matching is unlikely to be achieved in practice, but the tracking error in income obtained will be much smaller than with no duration matching at all.

In your second sentence, you are assuming 'growth funds' will continue to grow. It is quite possible that equity funds will fall by 50% (or more) and, in real terms, take more than 7 years to recover.

Interesting idea about fixed income bonds that reverse correlate to annuity rates.

Thinking about the likely outcomes in 7 years time.

Personally I think growth funds / equities are most likely to grow over a 7 to 10 year period, although as you said there is also a possibility that at some point during that period they could be down as much as 50%

I also think that UK annuity rates are likely to grow too - given the state of government finances.

Therefore I would also think that fixed income bonds reverse correlated (RCBonds) to annuity rates are most likely to fall.

So then thinking about what I would do in 7-10 years time.

Most likely situation - Equities up, Annuity rates up, RCBonds down.

Action:  Sell Equities, Buy Annuity, Keep RCBonds

Next most likely situation - Equities Up, Annuity Rates down, RCBonds up.

Action: Drawdown Equities, Drawdown Bonds, hold off on annuity

Next most likely situation - Equities down, Annuity rates Up, RCBonds down

Action: Probably none - but might sell what has gone down the least to buy a partial annuity, but more likely to hold off, and drawdown on what has gone down the least.

Least likely situation - Equities down, Annuity Rates down, RC Bonds up

(Which I think is what the OP is looking to mitigate against).

Action: Drawdown RC Bonds - hold off of buying an annuity until rates improve.

Personally I don't disagree with the idea of buying bonds - but I would be looking for a type of bonds or other assets that more reverse correlated to Equities,  than Annuities.

OldScientist

ukdw said:

OldScientist said:

ukdw said:

I think a plan based on taking an annuity in a certain number of years time is pretty tricky as rates could revert back to poor.  Also if you lower the potential growth of the funds intended to purchase that annuity you could also lose a large amount of growth potential too.

You can secure current rates by holding fixed income that matches the type (i.e., nominal or inflation linked) and duration of the annuity plus the delay time until purchase. Very roughly, the duration of the annuity is half of the unisex life expectancy (the value depends on yields, low yields gives higher durations and vice versa). For current inflation linked yields (1-2%), the approximation is close enough.

So how does this work? If yields go down, the payout rate of the annuity will also fall, but the value of the fixed income holdings will rise. With perfect matching, the rise in value will match the fall in payout rate and the amount of income secured will be the same as if yields hadn't changed. Of course, perfect matching is unlikely to be achieved in practice, but the tracking error in income obtained will be much smaller than with no duration matching at all.

In your second sentence, you are assuming 'growth funds' will continue to grow. It is quite possible that equity funds will fall by 50% (or more) and, in real terms, take more than 7 years to recover.

Interesting idea about fixed income bonds that reverse correlate to annuity rates.

Thinking about the likely outcomes in 7 years time.

Personally I think growth funds / equities are most likely to grow over a 7 to 10 year period, although as you said there is also a possibility that at some point during that period they could be down as much as 50%

I also think that UK annuity rates are likely to grow too - given the state of government finances.

Therefore I would also think that fixed income bonds reverse correlated (RCBonds) to annuity rates are most likely to fall.

So then thinking about what I would do in 7-10 years time.

Most likely situation - Equities up, Annuity rates up, RCBonds down.

Action:  Sell Equities, Buy Annuity, Keep RCBonds

Next most likely situation - Equities Up, Annuity Rates down, RCBonds up.

Action: Drawdown Equities, Drawdown Bonds, hold off on annuity

Next most likely situation - Equities down, Annuity rates Up, RCBonds down

Action: Probably none - but might sell what has gone down the least to buy a partial annuity, but more likely to hold off, and drawdown on what has gone down the least.

Least likely situation - Equities down, Annuity Rates down, RC Bonds up

(Which I think is what the OP is looking to mitigate against).

Action: Drawdown RC Bonds - hold off of buying an annuity until rates improve.

Personally I don't disagree with the idea of buying bonds - but I would be looking for a type of bonds or other assets that more reverse correlated to Equities,  than Annuities.

I think the point of locking in the income that can be obtained with a future annuity purchase is to fund retirement income rather than to look for the optimal solution. For example, currently a single life RPI annuity can be had at 60yo with a payout rate of 4.7%, i.e., if a 50yo retiree wants an inflation protected £10k per year and currently has more than £210k in their pot, they can earmark that in duration matched gilts* and (with some tracking error) ensure that at 60yo when they want to purchase their annuity they are able to secure the income they desire. This is essentially future proof - it requires no predictions of outcomes. That's not to say that the retiree cannot then alter their plan in the light of the outcomes you have suggested.

* This ignores the 10% or so return over 10 years arising from the current 1% to 2% real yields.

BookofShadows

OldScientist said:

I think the point of locking in the income that can be obtained with a future annuity purchase is to fund retirement income rather than to look for the optimal solution. For example, currently a single life RPI annuity can be had at 60yo with a payout rate of 4.7%, i.e., if a 50yo retiree wants an inflation protected £10k per year and currently has more than £210k in their pot, they can earmark that in duration matched gilts* and (with some tracking error) ensure that at 60yo when they want to purchase their annuity they are able to secure the income they desire. This is essentially future proof - it requires no predictions of outcomes. That's not to say that the retiree cannot then alter their plan in the light of the outcomes you have suggested.

* This ignores the 10% or so return over 10 years arising from the current 1% to 2% real yields.

Ok, so I think I like (and follow) most of that - but not sure how I could apply it in my current situation.  Let's say the idea of an inflation protected £10k income from 60 sounds like something I'd like to pursue with a chunk of my current DC pot.  I'm currently 51 and can't access that pot until 57 - but can obviously swap around investments within it, which are 100% equities funds at present.  There are only two options within the active Aviva pension I have for funds with gilts - both are index linked, the difference being an Over 5 years or Over 15 years fund.  

My typical approach for a lot of my finances has been to go for a sort of halfway house approach - not fully committing to any single path but not operating at the squeaky margins so comfortable to muddle along with the horizon generally looking 'ok'.  (examples, I'm overpaying the mortgage even though I know in the long run I'd have got better returns by stuffing even more into the pension - but I'm overpaying the mortgage at about a quarter of the rate that I'm throwing additional money into investments, and the investments are typically 75% going into the pension for the tax benefits, but some staying outside in SS ISAs for flexibility - lots of bases being attacked simultaneously but not 'optimised' for maximum growth but some psychological comfort from seeing everything 'improving')

So, following that sort of approach (and now recognising that I want some protection from my DC pot being halved just before I want to start accessing it in six years) and thinking I want to 'protect' around £10k a year (at 57) from market fluctuations without losing out on too much growth potential right now.  How daft do I sound suggesting converting say £100k of existing pension equity into the Index Linked Over 5 Years Gilts fund and then altering my future payment distribution so an initial ~£550 per month went into the Gilts fund every month (~20% of monthly payments at the minute) with that increasing a few % every year and some other chunks of the equity balance being shifted periodically if things are still up? 

I recognise this doesn't guarantee me £10k PA - but maybe it gets me some insulation and with a decent tailwind works well / ok (headwinds may mean 57 becomes 58).  

OldScientist

BookofShadows said:

OldScientist said:

I think the point of locking in the income that can be obtained with a future annuity purchase is to fund retirement income rather than to look for the optimal solution. For example, currently a single life RPI annuity can be had at 60yo with a payout rate of 4.7%, i.e., if a 50yo retiree wants an inflation protected £10k per year and currently has more than £210k in their pot, they can earmark that in duration matched gilts* and (with some tracking error) ensure that at 60yo when they want to purchase their annuity they are able to secure the income they desire. This is essentially future proof - it requires no predictions of outcomes. That's not to say that the retiree cannot then alter their plan in the light of the outcomes you have suggested.

* This ignores the 10% or so return over 10 years arising from the current 1% to 2% real yields.

Ok, so I think I like (and follow) most of that - but not sure how I could apply it in my current situation.  Let's say the idea of an inflation protected £10k income from 60 sounds like something I'd like to pursue with a chunk of my current DC pot.  I'm currently 51 and can't access that pot until 57 - but can obviously swap around investments within it, which are 100% equities funds at present.  There are only two options within the active Aviva pension I have for funds with gilts - both are index linked, the difference being an Over 5 years or Over 15 years fund.  

My typical approach for a lot of my finances has been to go for a sort of halfway house approach - not fully committing to any single path but not operating at the squeaky margins so comfortable to muddle along with the horizon generally looking 'ok'.  (examples, I'm overpaying the mortgage even though I know in the long run I'd have got better returns by stuffing even more into the pension - but I'm overpaying the mortgage at about a quarter of the rate that I'm throwing additional money into investments, and the investments are typically 75% going into the pension for the tax benefits, but some staying outside in SS ISAs for flexibility - lots of bases being attacked simultaneously but not 'optimised' for maximum growth but some psychological comfort from seeing everything 'improving')

So, following that sort of approach (and now recognising that I want some protection from my DC pot being halved just before I want to start accessing it in six years) and thinking I want to 'protect' around £10k a year (at 57) from market fluctuations without losing out on too much growth potential right now.  How daft do I sound suggesting converting say £100k of existing pension equity into the Index Linked Over 5 Years Gilts fund and then altering my future payment distribution so an initial ~£550 per month went into the Gilts fund every month (~20% of monthly payments at the minute) with that increasing a few % every year and some other chunks of the equity balance being shifted periodically if things are still up? 

I recognise this doesn't guarantee me £10k PA - but maybe it gets me some insulation and with a decent tailwind works well / ok (headwinds may mean 57 becomes 58).  

It sounds like your suggested approach makes good use of the limited choices you have on your DC platform. You're right that you might not guarantee the exact level of income, but holding the over 5 year index linked gilt fund should reduce the effect of changes in yields (and, eventually, income) - I cannot find the duration of the fund, but would guess from what info I have found is that it is around the 15 year mark. For future contributions, it is the contemporaneous annuity rate your are 'locking in' (so if rates rise, and fund prices fall you will lock in more income and vice versa).