Income drawdown vs annuity purchase at retirement

EdInvestor

Currently, you have to convert AVCs into an annuity, you can't take any tax free cash and you have to take them at the same time as the occupational scheme.

Next year the rules are changing. It's likely that you will be able to take tax free cash and put AVC money into income drawdown.It may be possible to take them at a different time from the occ scheme, depending on the company.

The details aren't yet clear - but some insurers are reportedly sending out statements to people coming up to retirement which don't mention that the rules are changing to their advantage.

Anyone who gets one of these letters might thus like to take advice about how next year's changes might affect them and what action they should take.

Rule changes also apply to contracted out (protected rights pensions).

dunstonh

In house AVCs appear to still be linked to the occupational scheme. Whereas FSAVCs will have the greater freedom that may allow that.

Its a bit hard for the insurers to issue much to policyholders when the full details are not yet known.

EdInvestor

How hard is it to say there may be changes that haven't yet been announced?

How easy is it to take people's pension fund and AVC lump sums without telling them they may not have to give up the money?

dunstonh

It seems that IFAs sell more investment-linked annuities ( eg With-profits annuities) than income drawdown plans.

Why is this?

After all, these annuities expose you to both investment risk AND you lose your capital.

At least with drawdown if you invest it well (and it's quite easy to obtain a yield of more than 5% with quite a conservative asset allocation so you don't need to dip into the capital) and your fund and income will grow.

That's not the case with the annuities. IMHO no-one in his right mind would buy one of these, yet people do.Why are these annuities apparently regarded as less risky than income drawdown?

Pal closed the annuity thread and referred it to here. I felt the above comments needed remarking on as it just highlights how dangerous someone who thinks they know about subject can be.

Firstly, the vast majority of retirement benefits are taken with a standard annuity. This is the no risk option.

Investment linked annutities can be desirable for the right person. I recently set up a with profits annuity with an ABR requirement of 0%. This means if the bonus is zero, the annuity remains the same. If there is a bonus payable that year, then the annuity increases. So at worst, if the annuity remains the same but has the potential for above inflation growth over the years. The advisor gets to select the ABR and this is important. Too high an ABR and your income could go down over the years. Although the starting amount would be higher too. A low ABR means you reduce the risk and try to balance risk against potential. Investment linked annuities are usually considered a medium risk and fit inbetween those that want zero risk and take the annuity and those that dont want the high risk of drawdown.

You keep saying that 5% yield is achievable. NO IT IS NOT. You should use the phrase potentially achievable. There is no guarantee you can get 5%. Even then, you still end up with lower initial income than an annuity. You just have to look at the stockmarket crash recently as to how things go down as well as up.

The annuity is not affected by that and the worse that can happen to a with profits annuity on zero ABR is the income remaining the same. Hence why they are considered lower risk than drawdown.

DavidLaGuardia

There are good arguments for both Drawdown and Annuities and it is clear that there are diffeent situations to warrant both of them.
Drawdown is an especially good tool when used in conjunction with phased retirement to reduce tax it can also be used temporarily to fund contributions to a stakeholder pension and thus convert part of the feeder fund into more tax free cash
Nevertheless There have been a lot of erroneous statements made on this thread and omission of some important risk factors:

Paraphrasing to avoid lots of copy/pasting:

Quote 1: “The annuity fund goes to the insurance company on death” This is misleading. Annuties work on cross subsidy. The gains from early deaths are used to provide for the losses from those who live longer.

Quote 2: “Drawdown can minimize the risk by investing in Gilts” This is a bad idea as drawdown needs to produce more than the underlying return of an annuity as the lack of cross subsidy means is a little thing called mortaility drag (see below)

Qoute 3: “Drawdown means that better investments can be used to combat inflation: If some risk is desired then annuities can be based on unit linked funds (not just with profits)

Two other risk factors exist under drawdown

A. Pound-Cost-Averaging. This observes the reduction in risk through making frequent small transactions rather than larger ones in one go and therefore being close to average prices rather than having the risk of deciding the right time to buy. It also demonstrates that a buyer (such as a regular investor) will gain proportionally more on low prices than they lose on high prices. The opposite applies to the seller (such as those in income drawdown). To make this easier to understand take an very simple example of a unit costing 110p one month, 90p the next and 100p the third month. The mean price over the three months is 100p. Therefore if one sells £100 a month one would expect to have sold 300 units over the period. In reality the number of units would have been (by month): 90.91; 111.11; 100.00 A total of 302.02 units

B. Motality Drag (taken from my post in anther thread)
First, it should be understood how a lifetime annuity works. In simple terms, a lump sum is given to an insurance company that agrees to pay back the sum over the expected lifetime of an individual based on a fixed underlying interest rate or the return on underlying investment after costs have been taken into consideration (It may be helpful to think of it as a loan in reverse from the perspective of the individual purchasing the annuity). Those who live longer than the mean lifespan of an '''annuity population''' are effectively subsidised by those who die earlier, and the insurance company usually assumes the risk of making this work based on acturarial assumptions. This is known as a '''cross subsidy'''. An individual may therefore suffer a '''mortality loss''' or '''mortaliy gain''' based on when they actually die. This is a risk they take on board in exchange the guarantee of income for the rest of their lives which cannot be predetermined.

When an individual delays buying an annuity, say between the ages of 60 and 65, the following occur:
A. Some of annuity population that would have purchased at age 60 will have died, meaning their subsidy has been lost to those those purchasing at 65.
B. While the total expected remaining lifespan will have decreased, the mean age of death in an annuity population entering at age 65 will be greater than for a group purchasing at age 60.

In practical terms, those with an invested amount may gain more from the growth of the investment such that they are still better off waiting until they are older to purchase the annuity. However, where an individual decides to take withdrawals from a given lump sum before buying an annuity the impact of mortality drag becomes very significant and increases exponentially with age.

For example, using imaginary actuarial assumptions, an individual with £100,000 can buy an annuity with an underlying interest rate after costs of 5% that gives them £8,024 at the end of each year based on a mean life expectancy of 20 years. Instead, they invest in an investment with a fixed return of 5% and take £8,024 at the end of each year. Three years later they use the residual investment, now worth £90,466, to buy an annuity. The mean remaining life expectancy according to the '''mortality tables''' used by the insurance company will not be 17 years but longer. Let us suppose it is 18 years. The annuity that can now be purchased would give £7,739 each year. In order to offset the reduction, the alternative investment used for three years would have had to return 5.47%. If an individual waits longer than three years, the additional growth required will increase over time, reflecting the exponential effect of mortality drag.

In conclusion, individuals with a good life expectancy may get more out of an annuity than is often appreciated

oceanblue_3

David - some excellent points.

There is also the danger of negative, or reverse, pound-cost averaging when taking income from a drawdown arrangement.

As you know, this works in much the same way as pound-cost averaging, but is capable of ravaging the value of the fund should withdrawals be made in a falling equity/gilt/coporate bond/property market.

I don't think the dark side have quite assimilated this concept!

Nick_C_4

Just wanted to say thanks to all for a fascinating discussion, especially DLG, dunstonh and oceanblue for taking the time to explain some of these concepts in great detail.

EdInvestor

oceanblue wrote:

I don't think the dark side have quite assimilated this concept!

I always try to look on the bright side myself

BTW it always strikes me as odd that some people assume a drawdown fund will always go down - while assuming a pension or endowment will go up ( by 4%,6%,8% etc).

All these funds can of course go up by even more if you're not paying any charges

The basic point with a drawdown is to make sure you don't draw out more than the fund has earned ( unless of course you are deliberately taking out as much as possible to reinvest elsewhere, in an ISA perhaps).

Let's say you've earned a 6% dividend return, and the capital has gone up by 3% . Take an income of 6% and reinvest the 3% so your fund will grow to beat inflation.

Some drawdown investors also like to keep their tax-free money in cash as well, as it reduces the risk of the overall fund. But IMHO it's better to keep part of the drawdown in cash and invest the tax free cash in high dividend shares, as the dividend income is tax-free to basic rate taxpayers and the interest in the drawdown fund is also tax-free.

Pal

It strikes me as odd that you always assume that income drawdown arrangements will go up in value by 5%+ a year.

EdInvestor

Pal

I'm assuming that the fund can generate income of c.5% a year: this is not hard if you don't pay charges, as those with savings accounts know

It's not necessary for the fund to go up in value.

Investors should preferably be able to cope if the income drops for a year to 4%, though this is pretty unlikely if it's well planned - but there's always some risk with every investment.