Is Income Drawdown likely to become more popular?

Loughton_Monkey

I was aiming to come to my own conclusion on this, and did some calculations, which I found rather 'strange'.

The Institute of Actuaries is thumping the tub again about increased longevity (based upon 2009 statistics) and this is bound to work through to further cuts in Annuity Rates. Interest rate assumptions for providers are also extremely unlikely to go up, and will possibly go down.

I was wondering, therefore, whether it is becoming rather silly to buy a 'standard' annuity, and whether Income Drawdown is now a 'no brainer', especially for those who (a) Maybe have a modicum of 'locked in' pensions already, with other funds yet to be taken, (b) understand that they are carrying the investment risk significantly longer, and (c) do not perceive that living a long time runs in the family.

As a test, I used a published 'best buy' annuity rate of 5.865% for a 60 year old, based upon a £100K starting fund. I coupled this with current official mortality tables (prior to any recent further reductions). What I find is this:

1. From the Pension Company perspective, the 'break even' interest rate they need to earn on a complete cohort of 60 year olds (assuming nil expenses) is just less than 2.01%. [Hence anything above this will pay their expenses and profits.]

2. For an individual 60 year old - who survives exactly for 21 years (the 'average' life span for a 60 year old), a fund earning 2.45% would be necessary for the pot to reduce to zero at this 'average' age at death. [Based upon the theoretical position that Income Drawdown until age 81 were possible].

[I think the difference in the two figures represents the 'profile' of when people actually die - which is not a straight line for the pension provider].

It struck me, therefore, that a yield of at least 4%, if not 5% or more would be reasonably achievable in any drawdown arrangement. This would give an opportunity for anyone to 'win' from a drawdown arrangement. The strategy would be as follows:

1. Take the drawdown, drawing exactly the same pension as a normal 'published' underwritten annuity. Death before age 77 would almost certainly provide a surplus to beneficiaries. [Hence, there is no mortality risk in this strategy].

2. At age 77, the fund remaining would provide significantly more than the pension quoted at age 60. [Don't have annuity rates for 77 year olds, but if the fund produced 5%, then at age 74, the remainder (of some £80K) could be converted to £6,625 at age 74 - a 'pay rise' of 13%]

However, I smelled a rat. These figures didn't look to me as 'profitable' for drawdown as they should do. The reason for this was clear once I did another calulation. I was astounded to find that using exactly the same investment rate of 2.01% (for a cohort of 74 year olds), the equivalent annuity rate for a 74 year old should be 9.85% and not 8.265%

So I have two 'discussion' points - especially for the IFA fraternity.

A. It is clear to me that the 'forced' annuity age (having been 74 until recently) has been deliberately 'screwed down' by the Pensions industry - since there must be a relatively high number of such customers 'forced' to buy an annuity. Do you believe this?

B. Even allowing for this 'anomoly', does Income drawdown make sense in principle for those happy to take normal investment risks?

yelf

Dont forget solvency 2. The problem is the majority of poeople simply dont have enough funds to justify the charges on drawdown. As well as thatb i think the "third way2 , which still needs major improvements, will become the norm for those getting advice.

dunstonh

I think the charges issue on drawdown is a red herring and less of an issue nowadays to what it was just a few years ago. The charges are typically no different to say a £10200 S&S ISA nowadays. Effectively, your retail AMC on the Unit Trusts. So, if its good enough for ISA and unwrapped investments then it should be good enough for pensions. The FSA have this peculiar fascination with pensions though in that they scrutinise pension charges (using rule RU64) but dont with other tax wrappers or unwrapped.

So, you end up with this situation where someone putting £10,200 in an ISA and drawing say 5% p.a. from it isnt given a second thought. Whereas someone putting £10,200 (gross) in a pension and taking 5% p.a. income from it is considered likely to be bad (or at least need a higher amount of justification).

Third way products seem to be on decline. A limited number of providers, most from the US, who do a lot of advertising and marketing but don't seem to be improving market share. Possibly as they are inflexible and when someone (who is of a sufficient risk profile to consider drawdown) looks at the pros and cons of third way products, I would think they would prefer the flexibility of conventional investments.

Short term annuities can be a solution for some but you have to be wary of mortality drag (although that issue is on decline).

Annuities have less to do with cross subsidy of the pool nowadays compared to gilt rates. The falling number of annuities purchased (drawdown already being a reason) and increased longevity has already decimated the annuity rates. That will only increase with the new rules. However, you will get the 1980s and 1990s over paying annuities (the double digit annuity rates) dropping off more over the coming years as those people die (the cross subsidy pool is still paying for those).

Loughton_Monkey

dunstonh wrote: »

I think the charges issue on drawdown is a red herring and less of an issue nowadays to what it was just a few years ago. The charges are typically no different to say a £10200 S&S ISA nowadays. Effectively, your retail AMC on the Unit Trusts. So, if its good enough for ISA and unwrapped investments then it should be good enough for pensions. The FSA have this peculiar fascination with pensions though in that they scrutinise pension charges (using rule RU64) but dont with other tax wrappers or unwrapped.

So, you end up with this situation where someone putting £10,200 in an ISA and drawing say 5% p.a. from it isnt given a second thought. Whereas someone putting £10,200 (gross) in a pension and taking 5% p.a. income from it is considered likely to be bad (or at least need a higher amount of justification).

This seems to confirm what I am thinking. I have never seriously obtained any 'quotes' or researched the charges involved but I have assumed that through HL (or similar) there would be similar charges as, say, an ISA.

So when, using 'market' annuity rates, you find that the 'embedded' interest rate on your fund - assuming average mortality (true for the pension provder, but unlikely for any individual) - is a measly 2% or so, my instinct is that you can do far better by a drawdown arrangement.

But, but, but..... my assertion is that although on paper you are gaining significantly, it seems that buying your pension at 77-ish is going to claw back the majority of your gains simply because the available annuity rates at that age are so abysmally poor.

dunstonh wrote: »

Annuities have less to do with cross subsidy of the pool nowadays compared to gilt rates. The falling number of annuities purchased (drawdown already being a reason) and increased longevity has already decimated the annuity rates. That will only increase with the new rules. However, you will get the 1980s and 1990s over paying annuities (the double digit annuity rates) dropping off more over the coming years as those people die (the cross subsidy pool is still paying for those).

It is understandable (although unwelcome) that each pension provider needs to claw back their own 'sins of the past'. This might explain lower annuity rates generally.

But what I feel is happening is that annuity rates as between ages is calculated inequitably. The older purchaser seems to be subsidising the younger purchaser, and probably - and more specifically - given the 'compulsory' (almost) purchase at an age dictated by HMRC is providing these annuity companies with an opportunity to give poor value.

As I calculated, the annuity rate for a 74 year old seems to be so poor that any provider who sells 1,000 such annuities will actually be paying out less, in cash terms, than the gross premiums. Is this partly a function of commission? Does a commission IFA get x% of the purchase fund irrespective of the age of the annuitant? If so, then it would help to explain why the older you are, the poorer the value.

sandsy

Loughton_Monkey wrote: »

2. For an individual 60 year old - who survives exactly for 21 years (the 'average' life span for a 60 year old),

This seems very low. Male lifespan at 60 is already around 26/27 years. The new figures from the actuarial profession suggest 27 and rising to 31 by 2040. See Appendix A, Table 3 of: http://www.actuaries.org.uk/sites/all/files/documents/pdf/cmiwp49.pdf

Using your best buy annuity rate, this implies a return of 3.6% necessary over 27 years, or more like 4% return if 4% is knocked off the purchase price to cover expenses, commission, current capital requirements and profitability (in line with FSA assumptions and not untypical based on my understanding). This is getting close to the 4.32% 30 year gilt yield.

Moving on.... the compulsory annuity purchase market is nearly 4 times as big as the income drawdown market. So in looking at the future, I guess one reason you have to ask is why the discrepancy? Why are people not using income drawdown as much as they could be at the moment? I get the impression that many advisers don't recommend drawdown for small pension pots or where there isn't already some sort of guaranteed income in place. So is behaviour in that regard likely to change as a result of the removal of compulsory annuitisation?

Loughton_Monkey

I have been working upon these figures:

http://www.statistics.gov.uk/downloads/theme_population/Interim_Life/iltuk-reg.xls

Have you tried a similar calculation for a 75 year old? I just wonder if that would produce a similar 3.6% return?

sandsy

Loughton_Monkey wrote: »

I have been working upon these figures:

http://www.statistics.gov.uk/downloads/theme_population/Interim_Life/iltuk-reg.xls

Have you tried a similar calculation for a 75 year old? I just wonder if that would produce a similar 3.6% return?

What is the best buy annuity rate for a 75yo?

Loughton_Monkey

They don't quote any higher than 74 - which is 8.265%

sandsy

2.8% or 3.4% if you allow for expenses etc - assumed 14yr life expectancy.

I'd expect it to be lower as age increases, not least because the mortality variability increases. But I'm surprised by the size of the difference.

Maybe they're cutting their margins very thin on lower age annuities as that's where all the marketeering goes on(best buys and all that) so trying to make up the profit elsewhere.

Interesting observations, LM!

sleepless_saver

Loughton_Monkey wrote: »

I have been working upon these figures:

http://www.statistics.gov.uk/downloads/theme_population/Interim_Life/iltuk-reg.xls

I'd be tempted to use the cohort life expectancy tables which make more sense in this context (I think!).

jamesd

Loughton Monkey, you're going to make your life company bankrupt. You need to use the cohort life expectancy tables, not period. Cohort = age that those who are currently at age 60 are expected to live to if they experience the expected changes in mortality rates each year for the rest of their life. It's more like 28 years at age 60 than 21, though I didn't check for this post.