Income drawdown, annuity - or both?
The new pensions freedom has opened the way for people to take greater control of their finances, but it also paves the way for grave mistakes. Deciding whether to take an annuity or drawdown has always been a difficult choice influenced by myriad factors, many unknowable, such as health, life expectancy, inflation, dependants and future changes to taxation.
In the past most people who took drawdown at least had access to professional advice, paid for through hefty commissions. However, the practice of receiving commissions in return for providing financial advice has been swept away by a government keen to improve transparency in the financial advice industry. Advice is now paid for with a fee rather than commission.
But this means people with newfound pension freedom but reluctant to pay an up-front fee may make poor pension decisions. The new government guidance service, Pension Wise is available to all retirees, but this amounts to just one 25-minute session of generic advice, and the issues are complex.
A pension saver must consider three crucial factors:
1. You may well live longer than you expect, and at the end of your life, the likelihood is that you will need some sort of care and support. Even if you are physically fit, you may not be up to running your investments.
At birth, women have a higher life expectancy than men: 82.6 years, compared with men's 78.7 years. By age 65, life expectancy is higher – men are expected to live for another 18.2 years and women for another 20.7 years, according to government data. That's a long time to maintain your standard of living.
Average life expectancies are based on data for the entire population, including those who die from childhood leukaemia, teenage accidents, mid-life heart attacks and other health hazards. This means your life expectancy extends as you get older and put these hazards behind you. At age 85 your life expectancy is still 6.8 years for a woman and 5.8 years for a man. Once you reach 90, you still have an average of four years left if you are a man and nearly five years if you are a woman.
You could well live many years longer than you expect. However, sadly, many people lose their ability to make good financial decisions long before they die. Research by Harvard professor David Laibson shows that we may all lose our marbles much more quickly than we hope.
His research shows, unsurprisingly, that 'crystallised intelligence' (skills, knowledge, experience) rises until the age of 60, but that 'fluid intelligence' (the ability to solve new problems) starts falling quickly in people as young as age 20. The average person's ability to make good investment choices plummets in a clear and dramatic way from middle age onwards.
Laibson's research reveals that people's ability to grip even basic mathematical calculations starts to fall away rapidly from age 50 and very sharply in their 60s and 70s. Laibson asked a group of octogenarians this question: if the chance of getting a disease is 10%, how many people out of 1,000 would be expected to get the disease? Only around 60% of respondents knew the answer.
For harder questions – such as: if five people all have the winning numbers in the lottery and the prize is $2 million, how much will each of them get? – just one third of the octogenarians answered correctly. And this cohort did not include people suffering with dementia, which in the West afflicts around 7% of those aged 75-79 and more than 30% of those aged 85-plus.
For the average person, the obvious retirement planning question is: who will look after you when you cannot look after yourself?
Clearly, most people, perhaps with the exception of the very wealthy, should consider buying an annuity that will provide peace of mind when they most need it and an income stream to cover basic bills. Fortunately, the rates available for annuities starting in your 70s are a lot more attractive than those beginning at age 60 or 65.
At the same time, it's opportune that the annuity market is expected to develop to include more flexible pension options, such as lump sum withdrawals and flexible death benefits. Some annuity providers will devise arrangements with lifelong dependant pension guarantees, which will be attractive to some married couples.
Laibson's research on the decline of our cognitive ability is so conclusive that he recommends a mandatory power of attorney should be given to a third party when people reach 65. For the record, Laibson was 45 when he made that recommendation.
2. The longer you keep your fund invested, the more opportunity there is to grow the fund, and this can make a massive difference to your retirement income
One side-effect of the new pension freedoms and our lengthening lifespans is that we can keep our pension pots invested in the market for several more years through the new, cheaper, 'anything goes' drawdown plans. Buying an annuity at age 60 or 65 will put an end to any investment growth in your pension pot, depriving it of compound returns for 15 or 20 years, just when it is at its largest.
Under drawdown you keep your pot in the market, allowing it to benefit from compounding, which will have a massive impact if investment returns are positive. The rule of thumb is that your pension fund will increase by 150% over 10 years, if your investment return is just 5% a year (£100,000 compounded twice a year at 5% for 10 years is £260,532.98 - £100,000 = £160,532.98). If investment returns are greater, compounding makes this figure shoot up.
The 'rule of 72' states that the approximate time over which an investment will double at a given rate of return, 'r', is calculated as 72 divided by r. So, for example, an investment that has a 6% annual rate of return will double in 12 years (72 divided by 6), while an investment with an 8% annual return will double in nine years.
Typically, therefore, only those in ill health are better served by taking out an annuity immediately on retirement, as they can take advantage of favourable rates (see table).
Impact of medical conditions on annuity values
|Sample qualifying conditions for enhanced rates||Age||Best standard rate||Worst standard rate||Improvement - best compared with worst standard rate||Improvement - JR* enhanced annuity compared with worst standard rate|
|Mini stroke four years ago||66||£3,001.02||£2,556.72||17.4%||23.3%|
|Smokes 10 cigarettes a day||65||£3,001.02||£2,556.72||17.4%||30.5%|
|Heart attack - one med for high blood pressure and one for high cholesterol||60||£2,681.70||£2,251.56||19.1%||30.8%|
|Lifelong asthma, type 1 diabetes and high blood pressure||65||£3,001.02||£2,556.72||17.4%||36.9%|
|Bowel cancer diagnosed within the past six months||65||£3,001.02||£2,556.72||17.4%||46.9%|
Notes: £50,000 purchase price. Annuity paid monthly in advance. No escalation. Five-year guarantee period. CM4 0JB post code. Adviser charge used based on the period 01/01/13 – 31/05/2013. Average factory gate adjustment 1.8%. Average adviser charge taken 2.2%. *Just Retirement. Source: Just Retirement
These important truths – that we're likely to live longer than we anticipate, and that additional years of investment can make a huge difference to a pension fund's value – point us in the direction of using a mix of drawdown and annuities in retirement planning.
One strategy might be to take drawdown in early retirement to maximise your pension pot, and switch to an annuity at around age 75 to avoid the hassle of having to manage your money and deal with the risk of outliving your funds. This is the model that pensions experts say they would recommend to their loved ones: moving from drawdown to annuity before things start to get difficult, which is more likely to be around age 70 or 75 rather than 80.
"We already split the retirement period between what we call 'active' and 'senior'," says David Hutchins, head of pension strategies at AllianceBernstein. "Seventy-five is the key date for annuitisation. Eighty is too late. Longevity picks up as a risk during your 70s."
3. You need to plan well and be mindful of market volatility to avoid depleting your fund
Unfortunately, there is no magic trick that will help you avoid depleting your pension pot prematurely. Here, compounding works in reverse. The more you can hold off from spending in the early years the correspondingly better your fund will be preserved.
Specialist adviser Intelligent Pensions points out, by way of example, that if you take £10,000 a year from a £100,000 pot (after withdrawing 25% cash tax-free), the fund will run out of money after 13.5 years if investment returns average 5%; but if you withdraw £7,000 a year, it will not be exhausted until 23.5 years after retirement - 10 years later.
Much depends on investment returns. Data crunched by Zurich Life shows that a £100,000 pot from which £6,000 is drawn annually would run out after 20 years if returns were low (1.5%) but after 29 years if returns averaged 4.5%. However, the power of compounding is such that a return of 7.5% would actually grow the pot to £120,434 by year 20. The 20-year figure for a fund growing at 4.5% is £51,484.
These calculations are challenging, especially given that the fixed rates used by most cashflow planning tools are dubious - investment returns do not come evenly. If you enter into drawdown in the early years of your retirement, as I'm suggesting here, you'll need to be aware that investment performance can be lumpy and that this will have a major impact on your pension.
To demonstrate this, Moody's Investment Services has compared two sequences of investment returns. The first has a 5% constant rate of return and the second has returns that jump around with a volatility of 15% - a more realistic pattern.
An investor aged 60 with a fund of £100,000 who takes a fixed annual income of £6,200 and suffers this 15% volatility runs out of money at age 85, some five to seven years earlier than his peer who enjoys constant investment returns – even though on average, the annual returns are the same. This highlights the need to keep reviewing your pension pot and, where possible, 'cut your cloth' in a bad year.
"Volatility is very important," says Zurich Life's head of government affairs Matthew Connell. "Often changes in investment indices from year to year are bigger than the amount of income being taken, so this makes picking out a glide path difficult.
"These factors mean it makes sense for people with large pots to go for a blended approach – for example, by using low-risk strategies for short-term planning or core expenses such as bills and council tax, and a higher-risk approach for longer-term or less essential goals such as inheritance planning. Another approach would be to stay in more volatile benefits while there is still time to ride out volatility, and go for an annuity in later life."
Annuities have been much maligned for their poor value, but scant credit is given for the fact that they take out a massive risk that you will live much longer than you expect.
"As a rule people are pessimistic about life expectancy but optimistic about investment performance," says Stephen Lowe, director at Just Retirement. "This needs to be watched closely if we are to avoid finding ourselves in the situation that Australia is now in, where there is concern that pensioners are depleting their funds too soon."
He points out that 22% of men and 31% of women are expected to still be alive at age 95. "To match annuity income to age 95 would require a guaranteed and stable rate of return of4.7% a year. Achieving such a rate of return means accepting investment risk."
New rules, new jargon
As of April 2015, people with money purchase pensions are able to choose any mix of these options:
- Income drawdown without limits and no need for reviews (now known as flexible or flexi-access drawdown)
- A series of sums or a single lump sum from uncrystallised funds (known as uncrystallised funds pension lump sums)
- A lifetime annuity
- A scheme pension: an individually tailored drawdown solution where the provider agrees to pay the investor a regular income from his own pension pot for life
This feature was written for our sister publication Money Observer
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
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.