Extra Retirement Income
John Whiteley is a Chartered Accountant who has spent most of his working life advising small businesses. He is the author of many books on personal finance, tax, and small business. He is author of several other How To Books including Going for Self-Employment, The Small Business Tax Guide and Watching the Bottom Line.
Many people have to supplement their income in some way when they retire. You may well have a lump sum which you have either saved or which you got when your pension plan matured. This chapter looks at supplementing your income by savings and investments. If you have no lump sum large enough to invest, you may be able to realise some of the value locked up in your home, and we also look in this chapter at equity release schemes.
General principles of saving and investing
What do you want to do?
If you aim for nothing, you will probably hit it. Many people feel they would like to save or invest, but it remains a vague feeling. They may succeed in putting aside some money in a savings account of some sort, but it goes no further. They have no purpose or aim in their saving. The savings they have may be a nice little nest egg, but if it has no direct purpose, it can too easily get used up on the first emergency, or even the first whim, that comes along.
Make it your first task to sit down and think about your aims. This will help you to structure your savings and investments. For example, if you want to save for your retirement, you will want to put your savings somewhere you cannot touch them until your retirement date. Otherwise, you might be tempted to use the money for something else, and find yourself short when you come to retire.
Here are some of the most common aims for saving:
- Generating an income.
- Protecting your capital.
- Combating inflation.
- Providing for your retirement.
- Passing on your wealth to the next generation.
- Putting a deposit on a house.
- Paying for education of your children or grandchildren.
- Having the holiday of a lifetime.
- Buying an expensive item such as a boat.
- Replacing a car.
In this chapter, we are thinking mainly about generating an income for your retirement, but you should also be aware of the possible other uses for savings. You may well want to use savings for a holiday, or to replace the car. Then there are also the occasions when some urgent repair may need to be done on the house. It is always wise to bear in mind the effect of inflation, so try to obtain from your savings an income that has at least the possibility of escalating year by year, particularly if you have no other income.
At all times, be aware of your changing circumstances, and plan your savings with them in mind. Changes usually happen slowly, and we do not always recognise them. Therefore, take time every so often – say every five years -to review where your life is and where it is going. Then make any changes necessary to your saving habits.
Keep it flexible
Unless you are endowed with powers of second sight, you do not know what the future holds. One in three marriages end in divorce, and a divorce can seriously upset the best planned savings and investment strategy. Divorce may be the most obvious wild card in the pack, but there are so many other things which can cause your plans to go awry – ill health, for example.
It is always a good idea to try to make your savings as flexible as possible. Ask questions about any investment you undertake, such as:
- Can I unscramble it if necessary?
- Is it readily realisable?
- Is the value liable to fall as well as rise?
- Can I pass it on easily to my descendants?
Evaluating the risk/reward relationship
When making your plans for savings and investments, you must decide about the degree of risk you are happy with. This does not mean that your degree of risk is set in concrete. You may change your attitude to risk at different times of your life, or depending on how much money you have to invest. Remember one of the first principles – review your circumstances regularly (and this includes a changing attitude to risk) and be ready to change your plans if necessary.
Evaluate the risk
There are some obvious pointers to a high-risk investment.
Assessing the quality of information
If you get chatting to a fellow at the pub, who you only know by sight, and he recommends a sure-fire tip for the 2.30 at Newmarket, you would not put all of your savings on it. If that same fellow offered to sell you some shares in a gold-prospecting company which had just found gold in the wilds of Alaska, your reaction would probably be the same.
Your assessment of the risk is coloured by your judgement of the quality of the information. One of the main factors in this is the trust and confidence you have in the person giving you the information.
But information always comes from someone. It may be the man in the pub, or the pages of the Financial Times, or anywhere in between those two extremes.
If you are at all uncertain, try to corroborate the information with someone in whom you have confidence.
What is behind it?
All forms of saving and investment have something behind them. Take, for instance, a Building Society account. By saving in this you are putting money into a large pool which is then loaned to people buying a house. That is very simple to understand, and very ‘transparent’. You can easily see that the ultimate investment of the money is in bricks and mortar.
Other forms of investment may not be quite so transparent. A name such as ‘General Amalgamated Consolidated Portfolio PLC’ does not really give any clue as to what your money would be invested in. So always make a point of trying to find out what is behind it. Is it a chain of seedy night clubs? Is it an international group exploiting the resources of the third world?
The most successful investors have a principle that they only invest in companies that are transparent and easy to understand. Try this as an acid test – can you explain the company and why you are putting your money in it to a ten year old?
How big is it?
A further indicator of risk is the size of the company or fund into which you are investing. Taking the example of the Unit Trust, look at the literature. What is the size of the fund? Is it several millions? Or is it tens of millions? Or for a company, what is the total market value of all the shares in issue? (This is known as the market capitalisation).
When you know how big the fund or company is, you can make your own decisions. This is one area where big may be beautiful, but smaller companies or funds often provide better performance.
How Marketable is it?
Another factor in judging the degree of risk attaching to a particular investment is the extent of marketability. The ultimate in marketability for company shares is, of course, the Stock Exchange. In order to qualify to be traded on the Stock Exchange, a company must meet stringent requirements. Anybody owning shares in those companies may sell them openly to any other willing buyer. The number of transactions on the Stock Exchange runs into millions every day.
At the other end on the scale could be a small family company. The shares may be owned by, say, mother, father, and two sons. If one of them wanted to sell their shares, the rules of the company may well say that they may only sell them to directors of the company. Even if this rule did not exist, it would not be easy to find a buyer outside the family willing to buy shares in that company.
In general terms, shares in smaller companies are not so marketable as shares in bigger companies.
Short term or long term?
In judging the degree of risk, you need to think about whether your investment is going to be short term or long term. This will affect your attitude to risk.
If you want to invest long term, you must take into account the effects of inflation. This is obviously not so important for the short term. Thus, if you want to put some money away for a specific purpose, and you know that you will be drawing it out in, say one year’s time or less, then a deposit with a bank or building society represents a low risk investment. For the same length of time, investing in shares on the stock market would be a high risk, because you would not be sure that you would not make a loss, especially when dealing costs are taken into account. Share prices can fluctuate, and they may have lost money in the short term, just when you need to take the money out.
If you want to invest long term, and not have to dip into the capital, then a deposit in a bank or building society would be a high risk. It would be virtually certain that the capital invested would be worth less in, say, ten or fifteen years’ time than it is now. That is because inflation will have eroded the purchasing power of the money.
Investing in shares for the long term is not so great a risk as for the short term. Historically, prices of shares have at least kept up with inflation. If you seriously believed that inflation would be negative – i.e. deflation – then the above advice would be reversed.
Timing has an effect on your judgement of risk. This is particularly so when looking at investments with a fixed term. The fact of a fixed term means that the circumstances at the time the investment matures are fixed. It may be that the value you receive at maturity is dependent on circumstances such as the amount of the Stock Exchange Index. Or the circumstances at the time of maturity may not be favourable for re-investing the proceeds.
As a general rule, investments with a fixed term are more risky than open ended ones.
Taking a risk
When you have made your assessment of the risk involved, you can then apply your own principles of how much risk to take when making your investments. If you are happy to take a fairly high risk, at least with some of your money, then you will want to look at the best returns available.
If you decide that some, or all of your money should be in low risk investments and savings, then you will look very carefully at the degree of safety. If there are any guarantees, you will want to find out exactly what is guaranteed. Then, within these guidelines, find the best return you can get for your money.
My book Managing your Money in Retirement (How To Books Ltd.) gives more detailed explanations of various forms of investment, and at the end of this book Appendix 3 gives more details about investing in stocks and shares, whilst Appendix 4 gives more details of investing in your country. Appendix 5 gives details of investing in life assurance policies.
You may have a large value locked up in your home, but how can you use it for your benefit?
You could sell the house and use the capital to invest and generate income. However, this has the drawback that you need to find somewhere to live when you have sold your house. You could, of course, rent a home. This means, though, that you have to be able to rent a home for less than the income your investment generates, otherwise you would be out of pocket over the deal.
You could also sell the house, buy a cheaper house, and invest the cash left over – this is known as downsizing.
This option could sometimes work if your children have all left home, and you do not need such a big house. However, do not underestimate the costs of buying and selling, moving, and making any necessary improvements to the new house.
The answer could lie in equity release.
So what is equity release? It is a way of raising money on the value locked up in your home. It is common for pensioners to be cash poor but property rich. They do not have much disposable cash or income, but they do have a large value in their house. Equity release is a way of accessing that value so that you have some of it in the form of cash which you can use either for income, or to spend.
Equity release is a mortgage loan taken out on the security of the house. This can in some circumstances be done where there is an existing mortgage, but more commonly, it is done where there is no mortgage outstanding on the house. The key feature of an equity release mortgage is that there are no monthly repayments to make. The capital only becomes repayable when you die, or when you and your spouse go into a residential home. Because of this feature, equity release schemes are really only suitable for older people. Currently, the earliest age at which equity release schemes are available is 60. This feature also means that the amount you can borrow is limited, and dependent on your age.
In the past, some equity release schemes were mis-sold. Therefore, all current providers of these plans should be affiliated to SHIP (Safe Home Income Plans). They should all have a negative equity guarantee. That means that they guarantee that when the property finally has to be sold, and the mortgage repaid, the debt will not exceed the proceeds of the property sale.
Steps to take
- 1.Gather information. There are many providers of equity release mortgages. Search the market. Always use an SHIP registered provider.
- 2.Talk to an independent financial adviser. They will look at your circumstances, and look at the whole market.
- 3.Talk about it to your family – that is, the people to whom you are leaving your estate when you die. This, of course, is most usually the children. In practically all cases, they will be in agreement that you should enjoy the benefit of the value in your house, even at the expense of them not inheriting as much as they might have done otherwise. However, it is always best to talk it over with them first.
- 4.Make your application to the company you (and your financial adviser) have chosen.
The present Home Income Plan market is made up of three main types of plan:
- Shared Appreciation Mortgages,
- Roll-up Loans,
- Home Reversion Schemes.
Shared Appreciation Mortgages
Under this scheme, you take out a mortgage secured on your property. You get a lump sum, and you can do what you like with it. The idea is that you invest this to produce an income. You do not have to pay back any interest or capital, as long as you continue to own and live in the house. When you sell your house, or die, the mortgage loan is repaid, and in addition, a percentage (typically 75%) of any increase in the value of the house since you took the loan is also repaid.
This type of scheme cannot be transferred from one house to another, so the loan must be repaid if you move house. This means that if you want to continue the scheme, a fresh loan application must be made each time you move house, incurring extra costs each time. There is no age limit to this scheme.
Under this scheme, you take out a mortgage secured on your property. You get a lump sum, and you can do with it what you like – again, the idea of this is that you invest it to produce an income. You do not have to make any interest or capital repayments, but the interest is ‘rolled up’ each year and added to the amount of your loan. The full amount is then repaid when you sell your house or when you die. In times of increasing house values, the increase in the value can keep pace with the increase in the amount of the loan.
Because of the compounding effect of rolling up the interest, you must be very cautious with this type of plan. The interest rates are variable for this type of plan, so that if interest rates increase, the compounding effect gathers pace. This also means that the loan to valuation for this type of plan should be very low – probably no higher than 20% should be considered as safe. A further effect of this is that the longer the plan is likely to be in effect, the greater the risk of running up a large debt. Therefore, you should not consider this type of plan until at least age 70.
If the loan reaches a point where there is a danger of the loan catching up with the property value, you may be asked to start making repayments. It could force you into the position of having to sell the house to repay the loan.
Home Reversion Schemes
Under these schemes, you effectively sell your home, in whole or in part, to the reversion company. You then get either a lump sum or an annuity. You are guaranteed the security of living in the home for the rest of your life, either rent free or for only a nominal sum. Then when you sell your house or die, the reversion company gets the proportion of the sale proceeds. This proportion depends on the proportion you sold the company when you took out the scheme.
The amount of lump sum you would get is never the full market value of the house, because the reversion company has to make provision for you living there for the rest of your lives. Therefore, the older you are, the nearer will be the price you get to the market price.
Questions to ask
Whatever type of plan you are considering, you must stop to consider various things which could become problems. Things to take into account are:
- Are any valuation, survey fees etc. reimbursed by the reversion company?
- Is the scheme transferable if you move house?
- Repairs and insurance – who is responsible?
- Will it affect any Social Security Benefits you receive?
- What do your family think about it?
- What would happen if you took out the scheme as a single person, then married?
- What would happen if you took the scheme out as a married couple, and one of you died?
- What would happen if you took the scheme out as a married couple, and you divorced?
- What would happen if a family member or friend moved in to care for you or provide companionship?
- What is the minimum age?
- What is the maximum loan to valuation?
- What is the minimum property value?
- Is there a minimum or maximum amount you can borrow?
- Is there a penalty for early repayment?
- Is there any restriction on the type of property (e.g. house, flat, maisonette)?