Avoiding the annuity trap

FatherAbraham

jamesd wrote: »

For drawdown I'd want a generous safety margin, perhaps 50-100% if planning on taking 5 or 6% income. That's still much higher income than the annuity with lots of protection and an inheritance at the end if the really bad cases don't happen.

I don't get you. You ramp the withdrawal rate up to 6% (which most retirement commentators would suggest is utterly bonkers), then, because that's so dangerous, you build in a safety margin of 100% extra capital? Doesn't that bring the effective withdrawal rate down to 3%?

jamesd wrote: »

Even moderate amounts of flexibility on income levels, instead of forcing 100% at high certainty, might make it possible to put together more competitive annuity products. Most people can take say a 10% or 20% income drop in exchange for more income if the really bad market outcomes don't happen.

If you only need 80% of the income, then buy a safe annuity for that 80% of the income, and invest the rest in a more flexible, higher yielding product. There's no need for a complicated, expensive, structured "hybrid-annuity" product from insurance companies -- the investor can assemble such a thing himself.

But there's still a need for a safe annuity to provide the 80% subsistence income.

I appreciate that you don't like annuities as the solution to entire retirement-income-provision problem. I think that's fair enough. I don't see any relevant response to my point that annuity rates are what they are, neither high nor low (unless we measure against people's ignorant expectations, rather than market reality), and (to echo grey_gym_sock's excellent points above) it's retiring so early with respect to one's life expectancy which makes things seem "expensive".

Here's Wade Pfau's (US-oriented) take on the place of annuities, and on retirees' failure to model them appropriately: http://www.marketwatch.com/story/it-pays-to-be-agnostic-on-retirement-strategies-2013-10-15?link=MW_latest_news

I liked the bit where he points out that using an annuity to provide the basic income in retirement can mean a higher legacy is left at the end of life, because surplus, non-annuity capital can be properly invested for long-term growth, rather than suffering the drag of regular withdrawals.

Warmest regards,
FA

gadgetmind

FatherAbraham wrote: »

You ramp the withdrawal rate up to 6% (which most retirement commentators would suggest is utterly bonkers), then, because that's so dangerous, you build in a safety margin of 100% extra capital?

That's pretty much exactly what I'll be doing.

However -
1) I want to max what I take at 20% tax. Extra can be stashed so actually spend rate will be close to 5%.
2) I'll drop the withdrawal rate after just over a decade later when state pensions kick in.

jamesd

FatherAbraham wrote: »

You ramp the withdrawal rate up to 6% (which most retirement commentators would suggest is utterly bonkers), then, because that's so dangerous, you build in a safety margin of 100% extra capital? Doesn't that bring the effective withdrawal rate down to 3%?

No, because in both annuity and drawdown cases you're taking the income as a percentage of the whole.

In the annuity case at 65 you might spend £100,000 to get £3,200 of RPI annuity income a year. In the drawdown case you might use that same £100,000 to start at £6,000 but be willing to drop that as low as £3,200 if there was a major and decade plus sustained market drop. Both with the objective of having no capital left at say death at age 120.

So take my cases, a minimum contingency unemployment target of £12,000 a year and a median pensioner income desired target for deliberate retirement, about £18,000 a year. To have very high confidence that I'm not going to end up below those I'll probably end up able to take £24,000* or £36,000 a year, being willing to drop that as required. Or just not take the higher income at all.

If you haven't done it yet it's worth doing some trials with Firecalc. While it's a US model its test cases for income and depletion due to adverse market moves are still useful. Particularly the scenarios where income is allowed to drop if asset values drop, which is the safety margin case.

5-6% when there is no objective to preserve capital, just as in the annuity case, is hardly bonkers or hard to achieve. All it takes is reasonable investment income and plans not to have the capital drawn all the way down to zero before some reasonably appropriate death age for the individual.

If there was a desire to preserve 100% of the capital then 4%-5% rather than 5-6% could be the way to go, depending on the balance of the desires for income and capital preservation. But of course an annuity is unsuitable for this, since it guarantees loss of capital.

FatherAbraham wrote: »

If you only need 80% of the income, then buy a safe annuity for that 80% of the income, and invest the rest in a more flexible, higher yielding product. There's no need for a complicated, expensive, structured "hybrid-annuity" product from insurance companies -- the investor can assemble such a thing himself.

The ability to drop the income in cases of prolonged drops in value could allows increased use of more efficient investments than gilts by annuity companies, since it protects them against that sustained bad returns situation. An individual can't match that with a combination of standard annuity and investment because the annuity portion would have too low a payout. But an insurance company could invest 100% of the money in a range of assets to deliver the higher payout, only dropping if specified events happen.

It's trying to find a way out of the trap that prevents insurance companies from getting decent investment returns - by constraining them to gilts - and hence forces them to deliver the low returns to retirees.

FatherAbraham wrote: »

But there's still a need for a safe annuity to provide the 80% subsistence income.

I agree, though not for 100% of that subsistence income, since drawdown with very pessimistic assumptions can be used for part of it.

FatherAbraham wrote: »

I don't see any relevant response to my point that annuity rates are what they are, neither high nor low

The rates are what they are, but they need to be compared to something and the natural something to compare them to is the alternative income that could be generated by not buying an annuity.

FatherAbraham wrote: »

Here's Wade Pfau's (US-oriented) take on the place of annuities, and on retirees' failure to model them appropriately: http://www.marketwatch.com/story/it-pays-to-be-agnostic-on-retirement-strategies-2013-10-15?link=MW_latest_news

I liked the bit where he points out that using an annuity to provide the basic income in retirement can mean a higher legacy is left at the end of life, because surplus, non-annuity capital can be properly invested for long-term growth, rather than suffering the drag of regular withdrawals.

Thanks, I'll take a look later.

*not really £24,000 because after reaching state pension age about £7,500 of the £12,000 income comes from the state pension, so it's only the income above that which has the safety margin at that age.

jamesd

gadgetmind wrote: »

That's pretty much exactly what I'll be doing.

However -
1) I want to max what I take at 20% tax. Extra can be stashed so actually spend rate will be close to 5%.
2) I'll drop the withdrawal rate after just over a decade later when state pensions kick in.

Yes, similar planning here, though in my case getting to the higher rate tax band would mean that either I've left retiring too late - wasted non-working time - or the more optimistic investment results have happened. And at my lower target income levels the state pensions play a more significant role for the long life case.