Drawdown or annuity? Crunching the numbers

It’s the retirement dilemma of our age: do you play it safe with a steady income for life, or take a higher risk in the hope of receiving more? Retirement options expert Billy Burrows cuts through the speculation by offering up some hard figures, to help you make up your own mind.

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Back in December I raised a key question: is it better to purchase an annuity or take regular income via drawdown?

If you’re approaching retirement, you’d probably love to know the answer to that one. And that (unfortunately!) means looking at some numbers.

But before we get to those, let’s get the goalposts in place. The first thing to understand is that you can’t make a straightforward comparison between annuities and drawdown. This is because they are very different beasts, working in completely different ways.

An annuity is actually a type of insurance. Specifically, it insures you against running out of income if you live longer than expected. Hence it pays you a guaranteed income for life – there is no central pot of money that can ‘run out’. By contrast, drawdown involves an invested pot of money from which you make regular withdrawals of income.

Let’s see how these compare in practice.

Peter and Susan (both 65) are in good health and have £100,000 left in their pension pot after taking 25 per cent of the pot as tax-free cash. Their overriding concern is to receive a regular income that can be sustained over the longer term – they don’t mind if they can’t get large lump sums.

Annuity or drawdown?

Peter could purchase a joint life annuity with gross income (i.e. before tax) of £5,106 per annum, and if he were to die before Susan then she would continue to receive two-thirds of this amount for the rest of her life. (Note that this calculation assumes the payments won’t increase with inflation, although it’s possible to buy an annuity that does this.)

So what about drawdown? If Peter were to set up a drawdown scheme instead, he could take out as much (or as little) income as he wants each year. However (because he and Susan want a sustainable income above all), let’s assume he draws exactly the same income as the annuity would pay.

Drawdown funds are normally invested in the stock market, so the value of the overall pot will go up and down each month depending on state of the stock market. This raises two important questions:

  1. What return does the drawdown fund need to achieve over the longer term to produce a higher income than an annuity?
  2. What level of investment risk are you prepared to accept if you are giving up the security of an annuity for the potential to be better off with drawdown?

Let’s tackle question 1 first.

What long-term return does the drawdown fund need to produce a higher income than an annuity?

Here’s a model of a drawdown plan where the income taken out is the same as the annuity would pay.  I have assumed that the fund will increase by 2 per cent each year, but I have not taken any charges into account. I have used 2 per cent because the current yield on 15 year gilts is about 2 per cent, and this is the interest rate used when calculating the annuity income.

As you can see, by age 90 the pension pot has nearly been spent.Drawdown steady income_version 2

If we assume that Peter lives until he’s 88, and Susan to age 90 then the drawdown will be on a par with annuity – assuming, of course, that the drawdown fund grows at least 2 per cent each year.

This means that the drawdown pot will need to increase in value by more than 2 per cent (plus charges) to beat the annuity.

To be precise, we have assumed that the annuity will continue at 66 per cent in years 24 and 25, because on average Susan could be expected to live  two years longer than Peter (it will of course continue to pay out to Susan however long she lives).

Were Peter to 88 and Susan to 90, then by that time the drawdown income of £3,370 (2/3rds of the orginal annuity) per year would have run out completely.

This demonstrates, using the most up-to-date life expectancy tables, that annuities and drawdown are neck and neck – provided that the drawdown pot grows by the same interest rate used to calculate the annuity payments (2 per cent).

However if the drawdown pot grows by more than 2 per cent (which is perfectly feasible), then the drawdown fund will win hands down.

So what about question 2 – the one about an acceptable level of investment risk? That’s very important too… but we’ve had enough figures for one day. Watch out for the answer to that one in part 2 next week.

Looking for pension advice? Find a specialist adviser here.

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Billy Burrows is an independent retirement options expert and industry commentator. Find out more at http://www.williamburrows.com