By Dale Critchley, Workplace Policy Manager, Aviva
The good news is that defined contribution pensions - which are likely to provide for most private sector workers once their wages stop - are flexible and should be able to cope with varying income needs over time.
If we consider a couple reaching their late sixties who are thinking about giving up work, they might have several more years to pay on their mortgage. Inflation may have eroded the value of their repayments, but it might still be a relatively significant outgoing.
Other factors might also influence the level of income they require.
Part-time working as part of a phased retirement might feature. They might need to draw on a small amount of pension to top up their income. This might increase as working hours are reduced or decrease as state pension becomes payable.
State pension age has been equalised, but a couple might not be the same age as each other – which is often factored into retirement planning. As a result, household income may reduce or increase at different points as earned income reduces and state pensions become payable. If partners want to give up work simultaneously there might be some years when a higher pension income is needed to facilitate this.
As part of an advice process, an adviser works out income and outgoings. This provides the income gap that needs to be filled by a pension. This is unlikely to be a single level of income that maintains pace with inflation throughout retirement.
It is even less likely to be a straight income line once ‘wants’ are added to ‘needs’. Generally, lifestyles in a person’s late sixties compared to their late eighties are not similar. The idea of a more active, and expensive, lifestyle in our sixties might be more appealing - even at the cost of a reduction in real-terms income in later life.
The cost of long-term care is a consideration. Once a mortgage is repaid, that housing wealth might help with those costs.
But why does any of this matter?
An index-linked pension has served generations of defined benefit savers very well and provided them with the income they need throughout their retirement. However, contribution rates into current defined contribution pension schemes are a fraction of those paid into defined benefit schemes. Unlike their defined benefit peers, defined contribution pensioners will need to preserve as much value as possible.
Striking the right balance between receiving an appropriate level of retirement income and making it last can be difficult. Just as taking more pension income in your sixties comes at the cost of later-life income, so it is that taking more income in your eighties means foregoing a more affluent retirement in your sixties.
Based on current annuity rates, a level pension for a 65-year-old which will be eroded by inflation over time, will provide an income of 7.31% of the purchase price each year. An inflation-linked annuity will provide 4.57% . Collective defined contribution (CDC) schemes which also provide an inflation-linked income, might provide more than an inflation-linked annuity but will still produce an increasing income that starts lower and might not match the initial income needs and wants of savers.
The move towards longer-term mortgages and more people paying mortgages well into retirement, is another reason why pension income will need to adjust over time.
Defined contribution pensions provide the building blocks to deliver an income that maximises a lifetime of pension saving. It is equally important those savers have access to advice, guidance, and tools to help them build a flexible retirement income that meets their individual requirements.
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