Which would you prefer, a marshmallow now, or two marshmallows later?

In a famous experiment cooked up by Stanford University academics, the marshmallow quandary was designed to test children’s willpower. But since 2015, pensioners have been playing their own version, with sweeping liberalisation of pension tax rules tempting thousands to take all their marshmallows today — and running the risk of leaving substantially fewer later in life.

The “pension freedom” reforms introduced in April 2015 sparked a pensions gold rush, with an estimated 500,000 cashing in guaranteed incomes for life and putting their pots into the stock market instead.

Historically high transfer values, prompted by unusual conditions in bond markets, were another carrot for those considering a move. But many of those who shifted money into the market did so just ahead of a sharp decline in global stocks.

Growing life expectancy and dizzying fees thrown into the mix mean many new pension millionaires have swapped gold-plated pensions for gold-plated problems. FT Money looks at the outlook for the transfer market and the inbuilt risks of a decision to grasp your “pensions freedom”.

The pensions gold rush

“I couldn’t believe it when I saw how much was being offered to transfer my pension,” says Nathan Jones, a 61-year-old employee of a FTSE 100 company. (His name has been changed at his request.) “I was embarrassed to talk about it, it was so large.”

Pension freedom rules gave over-55s unfettered control over their pension pots, allowing anyone the chance to transfer defined benefit pensions — one that delivers an income for life — into a cash lump sum or a more flexible, higher-risk, defined contribution scheme.

“My default all along had been that final salary pensions were the gold standard and you would be nuts to abandon one,” says Mr Jones, “But when I saw the value I was being offered I was stunned.”

Defined contribution pensions give savers more flexibility over how they can draw income and are easier to pass on at death. But the regulator has warned that most people with a defined benefit scheme would be better off sticking with the guaranteed income it provides.

This does not appear to have stopped savers from taking the plunge. The volume of money flowing from traditional “final salary” pension schemes more than doubled after freedoms were introduced, jumping from £7.9bn in 2016 to £20.8bn in 2017 according to figures released by the UK financial regulator following a freedom of information request.

A big attraction for savers has been eye-watering cash values to transfer out of defined benefit pensions, due to steady declines in the bond yields used to calculate pension liabilities. Transfer values rocketed to record highs in 2016, with those approaching retirement offered multiples of 30 to 40 times their projected annual pension income to transfer out.

Though such multiples have since fallen, at the end of last year a pension saver entitled to £10,000 a year from age 65 under a defined benefit pension would have been offered £235,000 to transfer out, a multiple of more than 20 times their expected income in retirement, according to actuarial firm XPS Pension Group.

Retirement savers in big company schemes have also witnessed the high-profile failure of companies such as BHS and Carillion — the construction services company which collapsed last year leaving an £800m hole in its pension scheme. The Pension Protection Fund steps in to protect workers’ pensions in such situations, but higher earners were often forced to take a cut on pension income.

The health of employees’ companies “certainly does come up with clients”, says David Gibb, chartered financial planner at Quilter Private Client Advisers, “[though] by the time the financial security of a company has become a concern, the trustees tend to have reduced transfer values, making them unattractive.”

Tom Selby, senior analyst at AJ Bell, says: “The decline of defined benefit pensions is likely to be a story that runs through into 2019, particularly as once-mighty high street giants struggle desperately to make ends meet.”

In the first three months of 2018 alone, pension transfers hit a fresh record of £10.6bn according to the Office for National Statistics, with the vast majority likely to be savers leaving final-salary pensions for more flexible plans.

When transfers make sense

Beyond the question of values, there may be good reasons to transfer from a defined benefit to a defined contribution pension.

“If someone’s money is in a scheme that looks to be at risk [it could be wise],” says Rachel Winter, senior investment manager at broker Killik & Co, “and if someone has a short life expectancy it can make sense. Or they may have a good reason for needing a lump sum, for example to look after a dependant.” Lump sums from defined contribution pensions can also be inherited free of tax if the pension holder dies before the age of 75.

But getting it wrong can be catastrophic. Being in charge of your own pot for life means ensuring it lasts — and the Financial Conduct Authority worries that many people have made the wrong investment choices. In 2016, the watchdog launched the Retirement Outcome Review. This looked into the pension market following the advent of pension freedoms and found consumers who had not taken advice were ending up in “investments that may not be right for them, including in cash”.

Last month, the FCA warned that up to 100,000 customers a year were “losing out on pension income when they access pension freedoms”.

What will you pay for a DIY Sipp?
PlatformAnnual administration feesDealing chargesDrawdown and other miscellaneous (selection of)
Hargreaves LansdownFunds: Tiered fee, 0.45% on first £250k, 0.25% on £250k-£1m, 0.1% on balances £1m-£2m.£11.95 for most deals, frequent traders pay lessEarly account closure fee of £295 if all money withdrawn as income and Sipp open less than 12 months.
Interactive Investor£100£10 for most deals, frequent traders pay less and admin fee includes trading credits£100 drawdown fee; £50 uncrystallised lump sum fee; £300 pension sharing on divorce.
Fidelity Personal InvestingFunds: 0.35% on balance up to £7,500 with a regular savings plan, £45 without, 0.35% on total amount after £7,500 threshold, to £250k. 0.2% on total if pot worth £250,000 to £1m. Max fee £2,000£10 for most deals, 0.1% for buying or selling an ETF or investment trust within a Sipp. No transaction charges for dealing in funds or to set up regular savings planNone
Source: Company websites

What will you pay and what will you get?

Anyone wanting to transfer a pot worth more than £30,000 must take financial advice before proceeding. But the high risk involved in such a transaction means far fewer advisers will do the work, and those who do charge a high premium.

Last year, a scandal in which hundreds of members of the British Steel Pension Scheme were persuaded by financial advisers to transfer their pensions also had a chilling effect on the market. MPs said pension savers were “shamelessly bamboozled” into signing up to unsuitable funds with high charges.

“This is the highest-risk piece of business an adviser can possibly provide,” Mr Gibb says of defined benefit transfers. “There is a lot of work involved and huge amounts of analysis and cash flow modelling. And the risk to the adviser is very high too.”

Some wealth managers, including Brewin Dolphin, do not advise on any defined benefit transfers. Others do, but nervously.

“We are very conservative and very cautious about defined benefit transfers,” says Chris Hill, chief executive of Hargreaves Lansdown, the UK’s largest online stockbroker. “You have to get advice and our advisers will do it, but our stance is to be very cautious.

“This is fraught with risk. There are a number of benefits that are very hard to replicate if you move into drawdown and people have to think very carefully about why they are doing it,” he says.

Advice firms levy an initial one-off fee for defined benefit transfer advice, usually a percentage-based charge on the value of the pension pot. Fees can be taken upfront, or on a contingent basis, where the customer only pays if they decide to go ahead with the transfer.

“Most [advice] companies charge a risk premium on top of their fee because they are having to take out private indemnity insurance to conduct the work and that is expensive,” says Andy James, head of retirement planning at Tilney Group.

Customers can expect to pay “several thousands of pounds” as a minimum, according to Ms Winter.

For those with large pots, the bills can be higher. Fees of between 1 and 2 per cent on the value of the pot are common, translating to at least a £10,000 one-off fee on a £1m pot.

Killik & Co, a wealth manager, charges 1.5 per cent of the cash value of the pot subject to a minimum fee of £3,750, meaning someone with a £500,000 pot would pay £7,500 for advice. St James’s Place, another adviser, can levy as much as a 3 per cent contingent fee for initial advice work.

Contingent fees are contentious. In January MPs launched a probe into the practice and critics say such fees incentivise advisers to give bad transfer advice.

Patrick Connolly, chartered financial planner at Chase de Vere, says: “You should pay a fixed fee to your financial adviser regardless of whether they recommend that you transfer or not.

“This is the only way that you can ensure that the advice they give you is solely in your best interests.”

A question of advice

If they decide to go ahead with a pensions transfer, investors face two main choices: to go it alone using an online fund supermarket, or leave the portfolio with a financial adviser.

The most hands-off, but expensive, option is discretionary portfolio management, where a financial adviser makes all of the decisions on an investor’s behalf and usually hands the investment management to a third party.

Under an advisory service, an adviser manages your portfolio, but consults you before making decisions.

Discretionary management tends to cost about 1 and 2 per cent a year. It will include an investment management fee as well as charges for trading and fees for the individual investments you hold. Advisers will also charge an hourly rate for some services too, at a UK average of £150 an hour.

That means ongoing charges for a £500,000 pot could reach £10,000 a year. Fees are commonly tiered, so investors pay lower fees on amounts over a certain threshold. Advisory services tend to be slightly cheaper, but still cost about 1 per cent.

Such large fees can be particularly galling when markets are falling.

“Our portfolio is currently under water of the transfer value two years ago by about 1 per cent after fees,” says Mr Jones. “So we have paid a lot for two years to go slightly backwards.”

Websites such as Unbiased.co.uk offer lists of advisers and it pays to be sure when choosing who to go with. High fees will cost you investment returns and they will often charge you to leave. “We like our advisers, but picking them felt a bit like a lucky dip and the whole thing all feels a bit like a black box,” says Mr Jones.

Brewin Dolphin discretionary management fees (based on illustrative £500,000 portfolio)
Investment management fee (1.3%)£6,500
VAT (20%)£1,300
Total management fees£7,800
Transaction charges (£20 per deal with 20 deals)£400
Stamp duty on UK equity purchases£165
Total transaction charges and levies£571
Underlying fund charges (0.68% ongoing charges)£2,618
Total illustrative charges over one year£10,989
Total illustrative charges as % of portfolio2.2%
Source: Company website

Picking the DIY route

Those who go it alone pay less, but face the burden of being in total control of their financial future.

Fund platforms charge annual administration fees, usually a percentage-based charge, as well as a range of other fees depending on how you draw your pension and the investments you choose.

Hargreaves Lansdown, for example, levies a 0.45 per cent charge on the first £250,000 of assets in a Self Invested Personal Pension (Sipp) and lower fees on assets above that. The charge is capped at £200 for those holding shares.

Customers of Interactive Investor pay a £100 Sipp administration fee and then £100 a year if they go into drawdown. In addition, customers pay an investment account fee of £22.50 per quarter, which comes with trading commissions.

Platforms have come under fire from the regulator for their “complex” fee structures. In its Retirement Outcomes Review, published last year, the FCA said charges relating to pension drawdown were “complex, opaque and hard to compare”, with some products boasting as many 44 separate linked charges.

Are the glory days over?

Those who have recently transferred their pension face another problem, having joined the market in the final throes of a record bull run for global markets which now appears to be creaking to a halt.

It has left many newly liberated pension portfolios teetering or losing value and investors can expect less rosy returns over the next decade than the one just gone.

In the 10 years to April 2015, for example, the FTSE 100 index delivered annualised returns of 7.11 per cent, while the S&P 500 index returned almost 10 per cent. Last year those indices shed 9 per cent and 4 per cent respectively.

Pension funds suffered during that period. According to finance website Moneyfacts, pension funds in 2018 suffered their biggest losses on average in a single calendar year since the financial crisis.

The average fund shed 7.3 per cent in the fourth quarter of 2018, leaving pension funds down by 6.2 per cent for the calendar year. Only 9 per cent of funds ended the year in positive territory, according to the Moneyfacts UK Personal Pension Trends Treasury Report, which assessed the performance of more than 5,500 pension funds.

Richard Eagling, Moneyfacts head of pensions, says: “Last year’s market downturn will increase the focus on the investment decisions made by pension savers and drawdown investors.”

Analysts believe the withdrawal of quantitative easing policies — which provided a monetary cushion after the financial crisis — and growing geopolitical issues will create a tricky environment for markets in the near term.

“The past 10 years have been incredibly strong for markets, helped by low rates, and it would be misleading to look at the past five- or 10-year performance and think that those will be the returns going forwards,” says Ms Winter.

Where to invest

Sipp investors may remain unflustered by short-term market risks. Since most will have decades in which to leave their money invested, they are more likely to be able to withstand some risk and market volatility to see their portfolio grow adequately over time.

The first step for managing a pension pot is to work out when you want to retire and what income you need in retirement. After that, consider inflation expectations and the likely investment growth of your portfolio to work out how much you need, and how much your pot needs to grow over time.

For example, according to calculations from online broker AJ Bell, someone with a £250,000 pension pot could retire at 65, take an income of £9,600 a year, increasing with inflation, and not run out of money until their 100th birthday, assuming an investment return of 4.5 per cent.

Ms Winter says those with longer term horizons should have a large chunk invested in a diverse mix of equity and equity income funds.

Asset allocation when you go into drawdown — or begin taking regular income from the pension — is trickier. Investors need to make sure they are not eroding the capital value of their portfolio by taking too much out. That means being flexible about income levels each year and having a larger chunk in cash-like assets and bonds, which are less volatile.

“The decumulation stage is fraught with the most potential downfalls, because if you remain invested and taking a set level of income but markets don’t perform well, you end up running down the portfolio faster than you wanted,” says Mr Gibb, describing the phenomenon of “pound cost ravaging”.

Popular funds among Sipp and drawdown customers

Hargreaves Lansdown

  • Baillie Gifford American

  • Baillie Gifford Global Discovery

  • EdenTree Higher Income Fund

  • First State Asia Focus

  • Fundsmith Equity

  • Jupiter Income

  • Legal & General International Index Trust

  • Lindsell Train Global Equity

  • Royal London Sterling Extra Yield Bond

  • Standard Life Inv Global Smaller Companies

AJ Bell

  • Fundsmith Equity

  • Stewart Asian Pacific Leaders

  • Jupiter European

  • Schroder US Mid Cap

  • Woodford Equity Income

  • Merian North America Equity

  • Vanguard FTSE UK Equity Income Index

  • M&G Optimal

  • Lindsell Train UK Equity

  • Artemis High Income

There are two main ways of taking an income from a Sipp portfolio. Investors who hold funds and shares that do not pay dividends must sell units in their funds to generate an income. Alternatively, investors who mainly own income-generating investments can live on the regular dividends produced by their portfolio.

Nathan Long, senior analyst at Hargreaves Lansdown, says: “Those looking to draw an income by selling from the capital should focus on minimising fluctuations in fund value, so they might blend absolute return funds alongside their more traditional funds.

“Taking only the income naturally generated by the funds means you won’t eat into the capital value of your pension,” he says. “Currently, income available from many equity income funds look attractive compared to bond funds, so there is an understandable bias to these type of funds in many portfolios.”

Mr Long says a good rule of thumb is to draw less than 4 per cent of your pension every year, to ensure your pension lasts “as long as you do”.

Hargreaves’ own Sipp customers favour equity funds such as Baillie Gifford American and Fundsmith Equity in their portfolios. Customers who have gone into drawdown choose similar funds, but have a higher weighting to equity income and bond funds.

According to AJ Bell, the most popular funds among its Sipp customers also include Fundsmith Equity, a global equity fund managed by veteran Terry Smith, as well as low-cost tracker fund Vanguard FTSE Equity Income index.

Based on a transfer value of £235,000, a portfolio spread evenly among AJ Bell’s 10 most popular Sipp funds since the advent of pension freedoms in April 2015 would have grown by now to £309,838.

Facing uncertain markets ahead, it can be tempting to take your pension pot in cash and stuff it under the mattress. Last year the FCA found some 33 per cent of drawdown customers were sitting wholly in cash. And according to online broker Interactive Investor, the average cash balance held in its customers’ Sipps increased by 11 per cent in 2018, “suggesting investors are nervous about reinvesting”.

However, even if the market outlook seems intimidating, the only good reason to sit on cash is if you need the money in the short to medium term.

“All you’re doing when you sit on cash is driving down your overall investment return,” says Mr James. But he says someone who is very worried could hold one or two years’ expenditure in cash. Ms Winter says six months’ expenditure in cash should be sufficient, providing someone is invested for the very long term.

“I haven’t regretted transferring my pension,” says Mr Jones. “And we don’t need to draw it down yet, so there’s no panic.

“But I suspect there are a lot of people out there like me, who have bought into a rising market and are now thinking oh dear, did we time this brilliantly badly?”

A tale of two transfers

Keith Black, a 51-year old consultant (his name has been changed at his request), consolidated several defined contribution pension pots into a personal pension in 2012, before the advent of pension freedoms, and manages the pot himself. But he has suffered from several poor investment choices.

“I had five different pension pots from different employment contracts, ranging from £15,000 to £5,000, and several years ago decided to consolidate them into one Sipp worth £80,000 and do it myself,” he says.

“I went to a seminar in 2012 with a panel of top financial advisers and bankers and they all warned that this was a risky thing to do, but I ignored them and ended up losing all my money through entirely my own choices.

I spoke a friend who said we should invest in oil and I just saw gold signs in my eyes. I got caught by the Arab Spring, and then some of the companies I owned went bust, and I lost pretty much 90 per cent of at least one of my investments.

“Soon £80,000 had become £20,000. Everybody said I should leave it to the experts but I like risk and thought there was a real chance I could increase my money. It really messed up my life for three or four years. Now I’m trying to keep investing with what I have left and take more time over it.”

John Kemp, 68-year old retired businessman, transferred a defined benefit pension before the pension freedom changes and has relished the extra flexibility that managing his pot has given him.

“I have never trusted big companies to look after me,” he says. “I moved my defined benefit pension into a personal pension a long time ago. I look at it as a hobby and I love it. It is my primary source of income apart from my state pension. I know there is a risk that if my investments don’t do well I’ll be in trouble, but I’m prepared to take that risk.

“My logic is to keep the fund at the same value while drawing my pension. I probably am drawing a bit more than I should right now, but I know I won’t need to draw as much when I’m older.

“I am still trying to balance today with tomorrow in that I like to have nice holidays — we’re going to Canada next year and it will cost a lot — but will be a memory forever.

“I can’t say I don’t feel edgy about the markets. It’s been a good few years. My fund did go down last year and I didn’t enjoy that, but I did expect it and I’m still ahead.

“I’m sure I’ve made the right decision in controlling my own money. I’ve enjoyed building up a balanced portfolio. You see people paying thousands of pounds in fees to people to manage their money and I just don’t think it’s necessary. I’m no expert but I think I’ve been relatively successful.

“A time will come when I won’t be able to manage it but I’m going to get one of my sons-in-law to manage it then. But hopefully that’s 20 years ahead. Until then, I want it to keep growing.”

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