Had you’d asked me 15 years ago how I planned to fund my retirement, my answer would have been straightforward.
- A certain proportion of my retirement income would come from a modest defined benefit pension, built up in the 1980s.
- The state pension would make up another modest slug of income
- The balance would come from an annuity, after I’d cashed in my pension savings.
These days, my thinking is a little more nuanced.
In particular I’m a hell of a lot less enamoured of annuities than I used to be. And a hell of a lot more interested in the alternatives.
Poor value annuities
For one thing, in the intervening years annuities have had something of a bad press.
Thousands of Equitable Life ‘With-Profits’ annuitants, for example, got royally shafted. Having exchanged their pension pot in exchange for an income for life, in the early 2000s they saw their incomes effectively halved – or worse — as the board of Equitable Life scrambled to conserve cash. Hardly a just reward for responsible saving.
Around the same time, annuity rates began a headlong plunge from which they’ve yet to recover.
Blame greater longevity, and increasingly derisory bond and gilt yields.
Hence the growing attraction of income drawdown, introduced by the government in 1995 to offer an alternative to annuities.
Income drawdown: Mine, all mine!
Income drawdown provides pension savers with the option of each year ‘drawing down’ a little of their pension pot, gradually consuming the income and eating bit-by-bit into the capital.
So instead of handing over your entire pension pot to an annuity provider in exchange for a guaranteed income, you draw down upon the capital sum that you’ve accumulated – deaccumulating, in today’s jargon.
At all times your pension pot remains yours – because you’re not handing it over to the annuity provider – and, upon death, what’s left can be passed on to your heirs.
Of course there are some downsides to income drawdown:
- There are charges that you don’t get with annuities.
- If you consume your capital too fast, you’ll drain your pot dry.
- Market volatility can mean that capital consumption when markets are down is especially expensive.
The biggie is that an annuity income is nailed-on for life when you buy it – albeit at a pretty poor rate today – which gives you security in exchange for flexibility.
Income from drawdown isn’t secure.
The annuity empire fights back
While miserly annuity rates have attracted a bad press in recent years, income drawdown hasn’t had that good a press, either.
I, for one, was initially put off – no, horrified – by some of the charges being levied by the Independent Financial Advisers and specialist firms offering income drawdown schemes.
Not to put too fine a point on it, some of the same firms that had been offering precipice bonds and zero-coupon bonds now seemed to be offering expensive income drawdown schemes.
Moreover, the traditional annuity providers apparently flooded the finance pages of the weekend press with scare stories. (Cynical? Moi?)
Take this one from the Daily Telegraph in 2012, which began:
Income drawdown: the pension that could leave you penniless
Avoiding annuities could give you more to live on to start with, but your money could soon run out if markets go against you.
The article warned that retired people who took the maximum income from their policies would empty their pensions by the age of 92 – even allowing for a relatively benign investment climate.
Er, yes. But why would you have continued to drawdown at maximum levels if you saw that starting to happen?
Income drawdown limits – imposed by the government explicitly to prevent pensioners from consuming their pots too fast, doubtless prompted by articles like the one just mentioned – also made for grim headlines over the years.
When in 2009 the government cut maximum drawdown from 120% to 100% of the gilt-linked (and already reduced) GAD1 rates, high-drawing pensioners’ incomes duly fell.
In other words, they couldn’t draw down as much as they has previously assumed – and it would be potentially imprudent to do so.
That wasn’t quite the way the Daily Telegraph pitched it, though.
Recent developments in retirement income
This sort of reporting, while ostensibly balanced, does little to encourage people to weigh up the pros and cons of annuities versus drawdown.
That’s particularly true if such people are reasonably sophisticated investors, who are used to taking decisions about their financial future, and who are perfectly capable of taking an educated view of the relative upsides and downsides of these two contrasting approaches to the deaccumulation phase of our lives.
People like Monevator readers, in other words.
And to my mind three recent-ish developments have tipped the balance even more in favour of income drawdown, and away from annuities.
Development #1: Equity income beats low annuity rates
In March 2009, the Bank of England cut Bank Rate to a historic low of 0.5%, ostensibly for a few months – perhaps a year at most.
Five and half years on, it’s still there.
And whereas the mood music even a couple of months ago was talking about a rate rise in a few months, the prospect of an imminent rate rise now looks slim, what with signs of a slowing economy here in the UK and further trouble in Europe.
In the meantime, annuity rates reflect these persistently low interest rates.
Consider the following annuity rates, sourced from Hargreaves Lansdown, in respect of a single life, investing £100,000 to buy an Retail Price Index-linked (RPI) annuity.
|Single life, RPI-linked,
5-year guaranteed annuity
Said differently, someone retiring at 55 is going to do so on an index-linked income of 2.25%. At 60, 2.3%. And at 65, 3.3%.
That’s pretty derisory, when you consider that a portfolio of solid income-oriented, dividend-paying shares could deliver double that yield between the ages of 55 and 64 or so.
Even at 70, your annuity will give you less than many decent dividend picks are paying out today – and with the annuity you’re kissing your capital goodbye, too.
Plus those dividends from shares should rise over time, providing a cushion against inflation. To be sure, not in a smooth and consistent way that’s guaranteed to match RPI. But very likely at a greater clip, overall.
In short, for investors prepared to shoulder the burden of picking shares or income funds – and taking on the risks of equity income – then income drawdown currently offers a higher income – potentially without necessitating any capital drawdown at all – and provides a potential capital bequest to boot.
Development #2: Goodbye, income cap
Remember those shrieking headlines about pensions being cut by £9,000 a year and pensioners facing a 40% income cut?
Er, that was then, and this is now.
As of the Chancellor’s most recent budget, the GAD limit was first sharply relaxed2, and then abandoned altogether in respect of drawdown schemes commencing from next April.
As pensions minister Steve Webb famously observed, there will now be nothing to stop pensioners withdrawing the lot, and blowing it on a Lamborghini.
Nothing, that is, except for the fact that – aside from the tax-free lump sum entitlement – such withdrawals would be at an individual’s highest marginal tax rate, calculated by including the withdrawal as part of annual income.
And nothing apart from the fact – as the government hastened to point out, post-Lamborghini foot-in-mouth – that it rather thought that people who’d been sensible enough to spend a lifetime accumulating a pension would probably be sensible enough not to blow it all at once.
Still, all in all your pension has just become one giant piggy bank, with no limits on how you choose to extract money from it.
Quite a contrast to swapping it for an annuity.
Development #3: Goodbye ‘death tax’
Thirdly and finally, the recent party conference season brought a welcome
bribe fillip to pension savers who have an eye on passing on the unused part of their pension to their heirs.
Simply put, the old 55% tax hit levied on your pension estate is to be scrapped, proposes the Chancellor.
- If you die before age 75, your pension can be inherited – and money withdrawn from it at will – with no tax to pay at all.
- If you die after age 75, the inherited pension will attract no tax if the funds are left within in it, but any withdrawal will be at an individual’s highest marginal tax rate.
Again, quite a contrast to an annuity.
The inheritance tax benefits are obvious, and already I’ve read press coverage suggesting that such a system would open the doors to multi-generational ‘trust funds’.
Needless to say, you can’t do this with an annuity, either.
Tipping the balance
So there we have it. Do these changes influence your view of income drawdown? Enough to tip the balance over annuities?
As ever, please do share your thoughts in the comment section below.
Please remember that these are difficult decisions with long-term consequences for your retirement and security, and you may need to seek professional financial advice. Our articles are for education and entertainment only, and are not meant to be taken as individual advice.