In my second blog on the budget announcement I want
to explore further the idea of annuities being dead…..
The table below compares drawdown income to an annuity:
|
|
Drawdown Income
|
Annuity Income
|
|
Pension Fund
|
£6,637.50
|
£4,538.00
|
|
Tax free cash
|
£750.00
|
£750.00
|
|
Total income
|
£7,387.50
|
£5,288.00
|
Note: based
on a male age 65, single life annuity with no increase, no guarantee and no spouses
pension. Tax free cash is assumed to be held on deposit at a rate of 3% p.a.
The alternative option is to take the whole fund as
cash. After tax this would be around £81,000, assuming this was held on deposit
at a rate of 3% this would give an income of £2,430 p.a.
Cash
Journalists have welcomed the idea that pensioners
have the flexibility to take their entire pension fund as cash. However to
achieve an equivalent drawdown income they would need to generate returns of
just over 9% a year to deliver the same income. Annuity income is slightly less
at 6.5%.
Taking the cash creates a number of challenges,
firstly how to achieve a return of 9%. There are potentially two options –
property or equities. A recent survey indicated that an individual could buy a
property in Blackpool for £75,943 and achieve a monthly income of £494.
However, ignoring tax there will be letting agent fees, insurance, maintenance
costs and periods when the property is empty which means the actual income is
less.
Assuming around £100 is set aside to cover costs
this means the yearly income is £4,728 p.a.
An alternative is investing, the Telegraph recently
suggested that 10% should be placed in short term government bonds and 90% in
the FTSE 100. Assuming a 5% return on the FTSE 100 over the past ten years, and
1.77% on Government Bonds this will deliver a yearly income of approximately £3,600
p.a.
Other potential challenges include inheritance tax
planning, flexibility around income and life expectancy.
With the tax upfront and limited investment options
cash seems a high risk option for a cautious investor, but may appeal to the
more speculative investor or those with other sources of income.
Drawdown vs
annuity
Drawdown provides people retiring with greater
flexibility because of the level of income they can take, the ability for the pension
fund to be passed down to their spouse and for it to remain outside of their
estate for inheritance tax planning.
However, there is a risk. Assuming the maximum
income of £6,637 is taken then the return needed is just under 9%. This means
that the individual will need to carefully manage their money to ensure that
the fund doesn’t run out. Assuming no growth the fund would disappear within 11
years. With an average life expectancy of 20 years, this means nine years of no
income.
In reality most people don’t take the maximum
income for this reason.
With an annuity the individual will know what they
will get each year until they die, this is guaranteed whatever happens.
However, to add increases each year, spouse’s pension and a guarantee means the
income will reduce. The provider of the annuity takes on the risk. Roughly on
£75,000, they are assuming a life expectancy of 16.5 years. If an individual
lives less than 16.5 years then the provider wins, if they live longer then
they win.
Flexibility
or complexity?
Journalists assumed that the budget meant an end to
annuities however the examples show that although there is flexibility
individuals may still prefer the security of annuities to drawdown (or cash) especially
where this is the only source of income.
There is greater flexibility now but it is no more
complex than it was before. What these changes do is provide individuals with
greater choice and as with all financial planning the right choice will depend
on the individual’s needs. The idea of having all the cash up front is
appealing but when it needs to be managed for an unknown period this perhaps
brings too much risk for many.
