David Trenner discusses the importance of adopting a phased strategy when moving from income drawdown to annuities.
The gilt yield in December 2011 was at its lowest ever level. The rounded down figure used to calculate maximum drawdown income using Government Actuary's Department tables is just 2.5%, and having only calculated rates for yields below 5% in 2006, the Government Actuary could be looking at a further calculation soon, as their minimum rate assumes gilt yields of 2%.
So, why would anyone want to buy an annuity now?
It is important to understand what an annuity does to answer that question. An annuity insures the policyholder against outliving his or her income. Henry Allingham, who died in 2009 aged 113 received income from an annuity for 53 years, clearly demonstrating how valuable an annuity could be. When Henry was 60 his life expectation would have been less than 15 years, although today a man of 60 can expect to live roughly twice as long.
The insurer providing Henry's income relied on surplus funds in the annuity pool arising from those annuitants who were less fortunate than he was. Many people seem to think that if they die after having purchased an annuity, the insurer keeps "all of their money". But when some of the annuitants died in their early 60s, the money which had been used to secure their annuities did not go to the insurer; it went instead to subsidise Henry's income. It is this cross subsidy which underpins all annuities.
Improving mortality however means that buying an annuity at 60 is rarely the right thing to do. The cross-subsidy (or mortality drag) at age 60 is only worth about 0.5% p.a., and locking into an investment in gilts for 30 years is a particularly cautious strategy to adopt just to get that extra 0.5% p.a.
Drawdown is generally not suitable for those with small funds, and indeed most drawdown providers will not accept funds below at least £50,000. Gone are the days when the likes of Equitable Life and National Mutual Life had minimum purchase prices of £10,000! Drawdown is also not suitable for those who are heavily dependent on their pension funds because they have little or no other savings. It is also not suitable for those with little appetite for risk and those who just want a guaranteed income.
However, for the ‘mass affluent' drawdown will be very attractive, particularly if they are able to retire in their early 60s. They will benefit from flexibility to vary their income to suit their changing needs, for example to take account of their state pension commencing. They will also benefit from preservation of the pension capital in the event of premature death, although death benefits arising from crystallised segments will be subject to a 55% tax charge. Perhaps most important they will benefit from the opportunity to achieve growth in their pension funds even after commencing to take benefits.
Once in drawdown, plans require constant monitoring. Investors' needs may change as may their attitude to risk. Perhaps most significantly they will have the opportunity to benefit from increasing mortality subsidy. Worth about 0.5% p.a. at age 60 this climbs to more than 3% p.a. by age 80. By this time the effect of the subsidy together with the effect of charges on a drawdown plan makes attaining the ‘critical yield' - the yield required under drawdown to match the alternative annuity income - most unlikely to be attainable.
But there is no one day when buying an annuity is the right thing to do. You might strike lucky and get the best possible rate, and you might get out of the markets at the top, but you are just as likely to be selling equities at a loss and buying an annuity when gilt yields have just plumbed new depths.
It is essential to link a drawdown strategy with a phasing in of annuities. By phasing the purchase of annuities from about age 70 to about age 80 - what we call ‘the decade of annuitisation' - you can spread the risk of movements in annuity rates and can take cash to purchase the annuity from selected funds which are showing a gain. This strategy reduces the risk of deferring annuity purchase and going into drawdown in the first place.
So, by all means defer annuity purchase and go into drawdown, but remember that because of the increasing impact of mortality subsidy the question should always be when to buy annuities and not whether to do so.
David Trenner is technical director of Intelligent Pensions
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