The pension guide for parents: securing the future
Planning for your retirement is essential in today’s pension market. If you fail to make the best investment decision, on retirement you may see your hard-earned pension fund dwindle away much more rapidly than you had first anticipated.
The pension industry has changed considerably in the last decade. Long gone are the days when a majority of people were working on a final salary based pension scheme from their company. Today most people invest into an independent pension fund that is used to purchase an annuity scheme on retirement. There may also come a time during your retirement that you decide it is best to take a lump sum payment to help your children or grandchildren financially.
Traditionally, a company paid pensions to retired former employees. The annual sum was based on the employee’s final salary. These schemes would pay out a set amount each month until the pensioner died. This method required the least amount of administration for the business and provided staff with a very secure retirement. Unfortunately this system is all but extinct now, as it is too costly for businesses to fund. People are now living for longer and traditional pension funds can no longer support the aging population.
First it was the private sector that abandoned this method, but as we are seeing in Detroit, this form of pension is quickly being abolished in the public sector too. It is far too costly for both private and the public sector to finance their employees throughout their retirement. Extended life expectancy combined with low interest rates means that these funds are simply not generating enough revenue to allow company pension plans to pay out at the full rate.
The new pension model: Annuities
A popular way to finance retirement has been to purchase an annuity upon finishing employment using the accrued capital from a pension fund; however, this system has been failing many pensioners in recent years. An individual can save into single or multiple pension funds while they are working, and savings are exempt from tax but the investment cannot be drawn on until retirement. When an individual reaches retirement age their pension fund is often used to purchase an annuity scheme, which will pay out a regular monthly sum until the death of the recipient. But be aware that annuities may not be the best investment for everyone, especially when interest rates are so low and returns are sometimes derisory.
Problems with annuities
Annuities are not an ideal investment model for pension funds because they are overly reliant on interest rates and inflation. Presently the amount that can be realized as a regular income from an annuity can be disappointing.
Annuity investment returns can vary greatly because of their tie to interest rates. Many schemes are variable and are tied to the stock market and interest rates; like all investments, their value can fall as well as rise. Low interest rates and a sluggish economy have reduced returns on annuities in recent years and many people are looking to alternative investments.
Some variable annuities now come with benefit guarantees but these are often very expensive to buy. These combine a 401(K)-like investment with an insurance policy that will kick in if returns fall below an agreed minimum level. Some insurers are now offering to buy back variable annuities with benefit guarantees, while others are raising fees. The slow investment market means that annuity insurance policies are often required to maintain the agreed annual payout.
Are there benefits to annuities?
Annuities do have a couple of advantages over traditional pensions. First, they allow you to use an unlimited pension fund, thereby creating a very comfortable retirement (if that sum is substantial). If you pay a high percentage of salary throughout your working career you could retire on a pension that might better a final salary based scheme, although in the present economic climate that is unlikely.
The second benefit is that they provide a way to defer paying tax while you are working. Money paid into your pension fund is exempt from tax. There is no annual contribution limit for annuities, unlike with 401(K)s and IRAs. This is advantageous especially for those who are close to retirement age and need to top up their pension fund.
In the final years of work many people achieve the highest salary of their careers while at the same time their children have fled the nest and the mortgage is paid off. Disposable income is suddenly at an all-time high, so investing for a happy retirement is the most sensible option. Annuities only really work now for people with very large pension funds that can afford to see little investment growth during their retirement.
When is the best time to surrender your annuity?
Most variable annuities have a surrender period during which time you may sell or withdraw money from the fund. Surrender charges will apply to money withdrawn and therefore reduce the return on your investment. This period is typically six to eight years and the charges usually decline each year. The WSJ recently issued some advice in an article: When to Surrender an Annuity.
You should only surrender your annuity after doing some research into the current market conditions and analyzing your options; it can pay to seek independent financial advice. Generally the time to surrender is when your annuity is no longer making monthly gains. If there are no gains on the investment the annual fees that are applied to the annuity fund will mean that it is losing money. However, it is generally always best to wait until the surrender charges are at their lowest.
There are some situations when you might want to surrender an annuity early; even with high fees being payable. If you require a lump sum payment and are confident that you have additional income coming in, surrender makes sense. Also, if you have been diagnosed with a medical condition which will likely shorten your life, taking a lump sum payment may be a sensible choice as this will enable you to invest the money into funds to help safeguard your children’s future.