Tuesday, 25 March 2014

Annuities vs drawdown vs cash

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
Tax free cash
Total income

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.


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.

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