Drawdowns and annuities – the rematch

Congratulations – you’re a year closer to retirement. But if it’s imminent, you’ll soon have to decide how you should access your pension pot. With the economic landscape changing all the time, pensions expert Billy Burrows brings us his regular update on the ongoing debate: drawdown or annuity?

Most people approaching retirement will soon have to face a tricky question: what’s the best way to take an income from my pension? You’re probably aware by now that a number of different methods are available, and that the choice is up to you. But which of those methods will represent the best overall value? And how sure can you actually be?

Some time ago I addressed that very question in this pair of articles, comparing the income from annuities with the probably returns of drawdown. But times change, and a lot has happened economically in the past two years. So it’s time to go back and see if the landscape has shifted, and how.

Quick recap: what’s an annuity, and what is drawdown?

An annuity is actually a kind of insurance policy. You buy one with a lump sum from the pension pot you’ve saved up, and the annuity then pays you a regular income that is guaranteed for life (and may also pay out to your spouse after your death). By contrast, drawdown is an arrangement for making withdrawals from your pension pot, which stays invested.

The advantage of an annuity is peace of mind and security, but there is no flexibility. The advantage of drawdown is the flexibility to control income payments, investment choices and death benefit options. The downside is the risk of the pension pot eventually running out, either due to taking too much income, or poor investment performance, or a mixture of both.

This means annuities are most suitable for those who don’t want to take the risk of running out of income. Conversely, drawdown is suitable for those who want flexibility, including the option of leaving money to their family after their death. In short they are very different beasts, so hard to compare directly – but we’ll have a go.

How things looked back then

Back in 2016, annuity rates were at historically low levels. You would only have needed your drawdown plan to beat a 2 per cent return (after charges) in order to take the same income as from an annuity. Assuming the same underlying rate of return, annuities and drawdown were neck and neck.

Over the last two years, annuity rates have fallen while the stock market has risen. This means that the underlying rate of return for drawdown has much been higher than for annuities, so those with drawdown schemes will have fared much better than those opting for annuity.

On the other hand, those with annuities have had virtually no risks to worry about. The same can’t be said of those using drawdown. The chart below shows the income from annuities and returns from the FTSE 100. The stock market (the orange line) is clearly a much more bumpy road, even if the overall direction is upwards during this period.

Changes to annuities

I’ve previously cited an example where someone aged 65, with a partner of the same age, buys a £100,000 joint life annuity. In 2016 they would have received an income of £5,106 per annum gross, with the surviving partner receiving 2/3rds of that income after the primary holder’s death. This is an income of just over 5 per cent per annum.

As of January 2018, the same £ 100,000 annuity would buy an annual income of just £4,725 – or £381 a year less. It’s worth mentioning that annuity pricing is complex, so not all annuities have fallen by that much, but the broad picture shows an overall decline in value.

Why are annuity rates still falling? The short answer is, ‘lower yields’. Annuity companies invest the monies they get for annuities into long term fixed-interest investments such as gilts and corporate bonds, and these yields have fallen. Without getting too technical, even a small drop in gilt yields gets magnified when it comes to annuities, so a 0.5 per cent drop can become a 5 per cent fall in annuity rates.

But it’s not all gloom

Now, just because annuity rates have fallen by between 5 per cent and 7.5 per cent in two years, doesn’t necessarily mean that by retiring today you’re worse off than someone retiring two years ago. Because that buoyant stock market has been working for you too. If your pension pot has been held in a manged fund equity fund, you should have seen your pension pot grow in value. This means you might have a bigger pension pot with which to buy your annuity – so to some extent the effects may cancel out.

Better news for drawdown

If it has been a poor showing on the annuity front, there’s been much better news for drawdown. The stock market has produced very good returns over the last two years, and in that time a typical medium-risk pension pot (about 60 per cent equities) will have increased in value by around 20 per cent. The caveat is that you can’t rely on this kind of performance continuing, or predict when it might end.

Investment returns

Generally you should take care when looking at investment returns, because the older you are, the less risk you should be taking. This is why a well-balanced investment portfolio should have a mixture of cash, bonds and equities to reduce the risk and volatility. This kind of fund may deliver lower returns than one that invested entirely in the stock market – but it’s also less likely to take sudden plunges in value.

What’s in store for the next couple of years?

Past performance is not a guide to the future, so never assume that drawdown will always provide better returns than annuities. All it needs is for yields to rise - and equity prices to fall - for annuities to move ahead of drawdown.

On the one hand, there are reasons to believe that long term interest (and therefore annuities) will rise. For instance, some experts are predicting higher yields if inflation increases in the future. On the other hand, some experts predict trouble ahead for the UK economy and stock market as a result of Brexit.

Looking to the future

No-one can predict how the economy will unfold over the next 25 years, so one thing is for certain: choosing how to convert a pension fund into income will remain one of the most difficult financial decisions. Annuities may be the underdog now, but this could change in the space of one more financial upheaval. Plan ahead for both scenarios with your financial adviser, and keep an eye on both annuities and the stock market, so you’re ready to adjust your plans if circumstances change.

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Billy Burrows is a financial adviser at Better Retirement and runs his own annuity and drawdown website www.williamburrows.co.uk where you can get up to date information on annuity rates.