How to crack investing for retirement income

More than nine years after the launch of pension freedoms, people are still crying out for help when they reach the point of drawing an income.

You’d think helping people make the most of their hard-saved pension pots in retirement would be a national priority. But there’s very little government guidance on “good practice” in this trickiest part of financial literacy.

As a nation we need that help. Research by asset manager Abrdn published this week found 23mn people (44 per cent of UK adults) have poor financial literacy, evidenced by their inability to answer basic questions about money. Almost seven in 10 (66 per cent) could not identify that buying a single company stock entails more risk than buying a fund that invests in the stock market on your behalf. And 42 per cent could not work out that if their money earned a lower interest rate than the inflation rate it would lose its spending power.

Meanwhile, another new report from Scottish Widows reveals a disconnect between what people want from their retirement income and the products they actually choose.

Eight in 10 people said they wanted a product which provided a guaranteed income for life — yet few customers are purchasing annuity products, which offer just that. And more than half (55 per cent) said that a predictable income was important to them for budgeting, yet most people currently select a product where their income depends on investment returns.

These are basic choices that are going badly wrong. But the actual choices are more complex — annuities come in various types with subtle but important differences. Plus, the majority who go for income drawdown face several challenges in managing investments while drawing an income. Keeping up with inflation is one, while another is “sequence of returns risk” — the risk of negative market returns occurring early in retirement.

Pete Glancy, head of policy at Scottish Widows, says: “The options at retirement can be daunting and complex, and people who can’t afford the services of an independent financial adviser may inadvertently make choices which do not meet their needs, and those of their family.”

Whether they get the right help, even if they can afford to pay for financial advice, is debatable. Readers may recall the findings of the Financial Conduct Authority’s Retirement Income Review in March, which revealed examples of poor practice across the market. 

Technology should be able to help. But there’s a frustrating lack of free tools to help people see whether their money will last through retirement

The regulator’s letter to chief executives of advice firms outlined the failings. The approach to determining income withdrawals was applied without taking account of individual circumstances, or based on methods and assumptions that were not justified or recorded.

Risk profiling was not evidenced, was inconsistent with objectives and customer knowledge and experience, or lacked consideration of their capacity for loss. And, perhaps worst of all, some advisers failed to ask customers about their expenditure, or did not explore future income needs or lifestyle changes.

Technology should be able to help. But there’s a frustrating lack of free tools to help people see whether their money will last through retirement. Guiide.co.uk is one of the few decent ones, though I hear more are in development.

Put all the findings together and we have hordes of financially illiterate people going it alone in drawdown. It’s a terrible situation.

There are positives. I’ve seen anecdotal evidence of people doing drawdown by themselves with a well thought out strategy. But there’s been little collective research on what drawdown customers without advisers are actually doing.

So I welcome a new report from Interactive Investor which shines a light on this.

The investment platform found DIY drawdown customers have a higher exposure to investment trusts and funds and a lower weighting to cash than those in the accumulation or “growth phase” of pension planning. There’s also evidence that drawdown investors’ use of investment trusts is designed to secure a reliable and regular income from their investments.

Popular drawdown portfolio holdings are Alliance Trust, F&C Investment Trust and City of London, which are all “dividend heroes”, having raised payouts annually for more than half a century. This trio of Steady Eddies is also highly diversified, which helps to cushion the impact of the inevitable volatility of investing in the stock market. 

It’s also worth noting that Alliance Trust has announced a blockbuster merger with Witan, which should bring its fees down. The share price of both trusts rose on the back of the news, which suggests the market thinks the deal provides decent value to both sets of shareholders.

Interactive Investor also found drawdown customers increased their holdings of passive tracker funds during the past two years, with five of the top 10 holdings in drawdown now passive funds. The platform thinks investors are attracted to the low fees and the simplicity of the approach.

This all seems very sensible. An October 2023 paper by Anarkulova, Cederburg and O’Doherty concluded that a simple, all-equity portfolio outperforms alternatives across all retirement outcomes, generating more wealth at retirement and providing higher initial retirement consumption. Surprisingly, the all-equity strategy also compared favourably in capital preservation, with households less likely to exhaust their savings and more likely to leave a large inheritance.

Meanwhile, a forthcoming publication by retirement income adviser Chancery Lane attempts to shed light on the question of how a pension is invested. I’ve had a sneak preview of the analysis, which calculates the income and capital generated by an investment of £100,000 in various types of portfolio over the 20 years to December 31 2023 vs the return from an retail price index-linked annuity.

It found investment trusts provide the best overall result, concluding the growth in the dividend income from 29 mainstream investment trusts is also likely to “deal with” inflation. I note that the period analysed in the study was particularly strong for stock market gains, but Doug Brodie, chief executive of Chancery Lane, says: “Income from a share is decided on twice a year by a board of directors using cash they already have, whereas capital values are a simple reflection of this morning’s share trades.”

It’s food for thought. And we need more of this type of research, especially independent research with no axe to grind.

There have been plenty of calls for policymakers to home in on the cohort approaching retirement who are still in the growth phase (and younger people) to encourage them to boost pension provision. But they also need to ensure that people can confidently visualise their retirement income and how that will be produced. It may require significant innovation. And it will definitely require investment in education.

That’s because sometimes the optimal retirement income solution comes with a degree of discomfort. An investor might be uncomfortable and still get a good outcome. Or they might need to feel uncomfortable to have a chance of a good outcome. Education will help them accept this. 

So to build on the success of auto-enrolment and help people engage effectively with the key decisions they need to take about drawing an income, we need cross-party consensus. With political upheaval likely in the months ahead, it’s time for an independent long-term savings commission to focus on retirement income and solve some of these issues.

Moira O’Neill is a freelance money and investment writer. She holds F&C Investment Trust and City of London. X: @MoiraONeill, Instagram @MoiraOnMoney, email: moira.o’neill@ft.com