Annuities-Online Blog

Pension Drawdown or Conventional Annuity?

With annuity rates constantly falling, is it time to consider alternatives to conventional annuity purchase until rates improve?

Pension drawdown is a way of taking income from a pension without having to purchase an annuity. It is available until age 75, beyond which it is possible to continue with the arrangement providing you have secured annual income of £20,000 or more (secured income is typically that from a pension scheme but not a drawdown arrangement). 

Pension Drawdown may offer the opportunity to defer annuity purchase until such time that pension funds or annuity rates have recovered. However, this is not without significant risks, so it is important to seek advice on the subject before proceeding.

The risks associated with pension drawdown are

• Charges
• Mortality Drag
• Investment Performance
• Changes to Annuity Rates

Charges: Pension Drawdown is not offered by all pension providers, so it may be necessary to switch pension provider and this is likely to involve costs (usually a percentage of the fund value – typically 3%). Holders of large pension funds (c£200k plus) may be able to negotiate a discount or agree a fixed fee for the work invloved. There will also be charges incurred while utilising Pension Drawdown (i.e. taking an income). Smaller funds (c£100k and less) may not be suitable for Pension Drawdown due to the costs involved.

Mortality Drag: Conventional annuities offer a cross subsidy between those people that die earlier than expected and those that live longer than expected. If you enter into an annuity pool later then you will not benefit from the cross subsidy from those people who died before you. To overcome this a pension fund must grow by a little more to provide the additional income to make up the shortfall that would not have ocurred if the annuity was purchased earlier.

Investment Performance:If a pension fails to grow by an amount that exceeds the income being drawn then it will fall in value. This leaves less money to buy an annuity in the future and therefore a lower income than you might otherwise have enjoyed. Of course, growth could exceed the amount of income being drawn and the fund would increase in value and provide more money to purchase an annuity in the future. We all know the addage about investment returns not being guaranteed, etc… the rate of investment return required to overcome charges, mortality drag and replenish the income drawn is likely to be in the region of 7%  (this will vary according to the level of charges and income drawn), so the risk that your future income may be less as a result of pension drawdown must be carefully considered.

Changes to annuity rates: Annuity rates have fallen significantly over the last decade. The reason for this is twofold; increasing life expectancy; and lower gilt rates, which provide the underlying investment return that supports the level of annuity payment.

Life expectancy may continue to rise for many years to come, so annuity rates will continue to be under attack from this. Gilt rates will eventually improve but it is impossible to say when this will be and they could certainly fall further before they rise (Currently the 15 year Gilt rate is 2.58% while 18 months ago it was c4.5%). Annuity providers may not necessarily use the 15 year gilt rate or change their underlying rates in line with movements to the 15 year gilt rate but it is a good benchmark to determine where annuity rates are heading.

To give an understanding of the effect in changes to life expectancy and gilt rates, we carried out a calculation under different variables (assume £100k purchase price, male aged 65):

•  Gilt rate reduces by 1%, no change in life expectancy: income decreases by £489pa (-7.6%)
•  Life expectancy increases by 2 years, no change in gilt rates: income decreases by £359pa (-5.6%)

Taking into account the results of our calculations, we would expect annuity rates to increase over the course of the next 5 years based on the assumption that gilt rates are more likely to increase by 1% before life expectancy increases by 2 years. Of course, there is no guarantee of this being the case and we may see further falls in annuity rates in the short-term.

To help you understand how income from pension drawdown may develop, taking into account movements in the underlying pension value, we have produced a Pension Drawdown Calculator. Results are displayed graphically to age 100 and compared against a conventional annuity.

In summary, Pension Drawdown is not suitable for eveyone but if a pension fund is of sufficient value (£100k+) and a person is risk averse then it may provide an opportunity to defer purchasing an annuity while providing an income in the mean-time.

If you would like to discuss pension drawdown then please call us on 0800 0337801