annuity vs drawdown - which pays more?

glasgow_oldie

My wife and I have accumulated a SIPP, and are trying to decide whether to buy an annuity or use a drawdown method in an unsecured and then alternatively secured pension (USP/ASP) in about 5 years time when I retire. I have read the forum discussions about the relative advantages and disadvantages, and clearly there are some strongly held views on either side. Nowhere could I find any calculators that enabled me to purely consider overall financial comparisons between the two arrangements. I posted a thread asking if anyone on these forums knew of one, but no-one responded despite over 100 views. Therefore I have written my own spreadsheet in Excel to calculate the annual income from various permutations of income and growth of an USP/ASP compared with an annuity.

My understanding of the USP/ASP arrangements is that the pension fund can transfer entirely to the surviving spouse and thus functions like a 100% joint life annuity. On death of the last survivor of the couple with no dependents, the remaining amount of the pension can be left completely to a charity, but I have not been able to find out exactly what is the tax situation if you want to leave it to other relatives. I believe it is heavily taxed, at 35% initially and then subject to a further 40% IHT and therefore very little can be left to other relatives, but I am not certain of this.

I have therefore compared the differences between a drawdown pension from an USP/ASP with a joint 100% life annuity for a man buying a pension at aged 65 with a £500,000 pension fund whose spouse is aged 57. I have calculated 2 different types of pension income, level and increasing by 3% pa, and with 2 different rates of growth of the remaining invested pension fund, 3% and 4.5% pa.

I used the FSA tables for annuities and a gilt yield of 3.75% to calculate the drawdown amounts.


Obviously, I have had to use some fairly unrealistic assumptions, egt the gilt yield used to calculate the basis amounts for USP/ASP remains the same for 30 years
Is there any prevailing wisdom on what is likely to happen to gilt yields in the next 10 – 15 years??!

Example 1

level annual income
growth in pension fund = 3%pa
starting pension = £27132pa (=100% joint life annuity)

USP/ASP
Average income per decade
65-74 27132
75-84 23880
85-94 12941
Cumulative amount withdrawn by
75th birthday 271320
85th birthday 510118
95th birthday 639527
Size of remaining pension fund
75th birthday 368481
85th birthday 200275
95th birthday 103261

With USP/ASP, at age 78 income of £27132 would exceed the maximum permitted, so income declines from then on Income aged 95 = £9434

Example 2

level annual income
growth in pension fund = 4.5%pa
starting pension aged 65 = £27132pa (=100% joint life annuity)

USP/ASP
Average income per decade
65-74 27132
75-8 27132
85-94 22825
Cumulative amount withdrawn by
75th birthday 271320
85th birthday 542640
95th birthday 771492
Size of remaining pension fund
75th birthday 428078
85th birthday 316385
95th birthday 192512



With USP, at age 86 income of £27K would exceed the max USP permitted, so declining income from then on
Income aged 95 = £18198

Both example 1 and 2 are to compare with the results of an annuity as

income pa 27132
Cumulative amount withdrawn by
75th birthday 271320
85th birthday 542640
95th birthday 813960
Example 3

Annual income growth = 3%pa
growth in pension fund = 3%pa
starting pension aged 65 = £17328pa (=100% joint life annuity)

USP/ASP
Average income per decade
65-74 19865
75-8 26025
85-94 18834
Cumulative amount withdrawn by
75th birthday 198646
85th birthday 465813
95th birthday 647233
Size of remaining pension fund
75th birthday 448904
85th birthday 301627
95th birthday 165836


With an ASP, at age 83, income would exceed the maximum permitted, so income declines from then on.
income aged 95 = 13355 (40834 with annuity)

Example 4

Annual income growth 3%pa
growth in pension fund = 4.5%pa
starting pension aged 65 = £17328pa (=100% joint life annuity)

USP/ASP
Average income per decade
65-74 19865
75-84 26696
85-94 32350
Cumulative amount withdrawn by
75th birthday 198646
85th birthday 465609
95th birthday 789110
Size of remaining pension fund
75th birthday 524158
85th birthday 484722
95th birthday 335444

With an ASP, at age 90, income would exceed the maximum permitted, so income declines from then on.
income aged 95 = 31867 (40834 with annuity)

Both example 1 and 2 are to compare with the results of a 3% pa annuity as

Average income per decade
65-74 19865
75-8 26696
85-94 35878

Cumulative amount withdrawn by
75th birthday 198646
85th birthday 465609
95th birthday 824386


Example 5
Take the maximum possible drawdown from USP/ASP, with 5 yearly review of an USP and then annual review for ASP.
growth in pension fund = 3%pa

Average income per decade
65-74 40200 for 5 years, then 33678 for 5 yrs
75-84 15442
85-94 8490
Cumulative amount withdrawn by
75th birthday 369390
85th birthday 523814
95th birthday 608717
Size of remaining pension fund
75th birthday 259843
85th birthday 135973
95th birthday 74759

Income aged 95th birthday = 6021


Example 6
Take the maximum possible drawdown from USP/ASP, 5 yearly review of an USP and then annual review for ASP.
growth in pension fund = 4.5%pa

Average income per decade
65-74 40200 for 5 years, then 36810 for 5 yrs
75-84 19661
85-94 12491
Cumulative amount withdrawn by
75th birthday 385051
85th birthday 581662
95th birthday 706575
Size of remaining pension fund
75th birthday 304416
85th birthday 185914
95th birthday 118117

Income aged 95th birthday = 12670



My conclusions from this exercise are

Annuity


Advantages

• Simple
• Always returns more cash to the couple in their lifetime, subject to my assumptions that gilt yields remain the same for USP/ASP and growth rates of the pension pot in USP/ASP are less than 4.5%. I have not put this table in, but you need an annual growth of 6% in the pension fund before the USP/ASP pays more to the couple than an annuity (and this would still leave £179331 in the pension fund at age 95.)

Disadvantages

• No further changes possible. If gilt yields rise subsequently, it is possible you could have obtained a higher pension if delayed buying an annuity.

USP/ASP

Advantages

• Can leave either a large sum to charity on death of the last of the couple (instead of taxman or an insurance company), or a much smaller sum to estate. Combined total of paid pension to couple and remaining sum on death of last survivor always exceeds that paid out with an annuity provided growth rate is at least 3% pa in the pension fund.
• if growth rate of pension fund exceeds 6%pa, then will pay more to couple than an annuity

Disadvantages

• Income may decline in later years as the maximum amount that can be withdrawn is capped by the size of the remaining pension fund. If fund only grows by 3%, then the income at age 95 would be a miserable £6000 if you have taken the maximum from the pension.

• Pension income very sensitive to growth obtained in remaining pension fund. – the difference between a 3% and 4.5% growth rate is quite considerable.

• Risk of course that the pension pot may actually decline unless risk free investments are chosen. This could be catastrophic in later years when income is already declining when the maximum permitted amount has already been reached.

• Hassle and fees and worry of managing the pension may be considerable, especially as get older. If I wanted to increase my pension every year, my SIPP provider would charge £900 per 5 years in management fees.

I am fairly confident these figures will be in the correct range, but would be grateful for any expert comments or advice on the accuracy of these figures. I have not accounted for inflation or the effect of management fees for USP/ASP arrangements.

EdInvestor

You're not really comparing like with like.You can only really compare how much can be extracted from the pension fund plus the residue remaining under each system over a given number of lifetime years net of fees and charges.