Annuity vs pension drawdown: is there a clear winner?
New figures produced by Zurich outline just how difficult it is to estimate whether going into drawdown or buying an annuity offers the best value for money in retirement.
In a report published earlier this year, pensions expert Dr Ros Altmann argued that 65-year-old couples would be unlikely to benefit from purchasing a standard annuity, given the average life expectancy and how long it would take to earn back their initial capital.
Altmann calculates instead that, if a couple invested a £100,000 pension pot and received even modest returns of 3.5%, they would not run out of money until they were over 90 years old after taking an annual income of £6,000 - in line with typical single-life annuity rates.
Taking a lower income of £5,500 a year - in line with current joint-life annuity rates - would mean there would still be more than £15,000 left in the pot when the couple turned 91. On this basis, Altmann argues that annuities are often poor value compared to investment and drawdown.
Indeed, research earlier this year found that only one in four people planned to take an annuity when they retire.
However, new research by Zurich suggests that the situation is much more complicated than that.
Applying the same projection rates used by the Financial Conduct Authority (FCA), returns of 1.5, 4.5 and 7.5% for products without tax advantages, Zurich's Dr Matthew Connell found that a £100,000 pot from which £6,000 was drawn annually would run out 20 or 31 years respectively for the low and middling returns, while high returns would more than compensate for the amount drawn, meaning the pot would actually grow over time.
If you account for charges of 1%, the pot runs out after 18, 26 and more than 35 years respectively.
Connell also points out that volatility can play a big part in investment performance once retirees begin drawing from their pots. While they are contributing, the investment will generally ride out the ups and downs. Once they start taking money out however it becomes much more difficult for the investment to recover from ill-timed dips.
"Often, changes in investment indices from year to year are bigger than the actual amount of income being taken, so this makes picking out a 'glide path' difficult."
"Indeed, Moody's has estimated that different patterns in volatility could make a retirement plan run out five to seven years earlier than FCA projection rates would suggest, even with the same overall return over the long term."
Finally, if the retiree wants their income to increase along with inflation - so for example take £6,000 the first year, £6,120 the next, £6,242.40 the year after that and so on, to account for 2% inflation - the pot would deplete even more quickly.
In this scenario a pot subject to low investment returns would run out in its 17th year before fees, and a year earlier if including fees of 1%.
A pot with middling returns would run out in its 22nd year (or its 20th with 1% fees) and one with higher returns would grow until its 24th year, when it would begin gradually contracting.
Be aware however that an annuity similarly linked to inflation would pay out significantly less on £100,000. According to the Financial Times, a single life annuity linked to Retail Price Index inflation with a five-year guarantee would pay only £2,448 on a £100,000 pot to someone aged 55, up to £5,952 for someone aged 75.
According to Connell, these additional factors suggest deciding if an annuity is good value compared to drawdown is far from clear-cut.
He says people might take up different tactics to blend the security of annuities with the benefits of drawdown. These could include taking an annuity to cover basic necessities and bills while keeping the rest of the pot invested, having several 'buckets' with different risk profiles for different points in the future, or a transition from having everything invested to relying completely on one or more annuities.
This feature was written for our sister website Money Observer
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.