The pension conundrum: buy an annuity or use drawdown?

Falling bond yields have pushed annuity rates to near record lows, but is it right to risk all on the ups and downs of the stock market?

The value of investments can fall as well as rise, and you may get back less than you invested. Past performance is no guarantee of future results
Pension

What are the options when I retire?

With defined benefit pensions all but extinct in the private sector, those controlling their own pension pots have greater responsibility than ever before for determining the quality of their retirement. The big question that everyone faces is whether they should go into pension drawdown or buy an annuity?

An annuity gives the retiree a guaranteed income, but with caveats. If you want inflation-linked income, a fixed-term guarantee (so that some income can be paid out even if you die immediately), or to make it ‘joint life,’ the rate you receive will be driven lower. In general, annuities work well if you live for a very long time, but less so if that’s not the case.

Retirement drawdown puts the responsibility into the hands of the retiree. If your investments perform poorly, you spend too fast, or a combination of both, then you risk ending up impoverished. However if your investments perform well, as they have done over the past decade, then you may be able to improve your financial position.

Annuity rates are near record lows

In November 1994, a man aged 65 could receive an income of £11,145 on a £100,000 annuity, non-inflation linked. Fast forward to November 2017, and that same man would be able to get £5390, half the amount, or a mere £3287 retail price index (RPI) linked, and with a five-year income guarantee. Recalling that the Office for National Statistics (ONS) expects the average person in Britain to live another 17.6 years aged 65, this is a fairly unappetising return.

With the cheapest FTSE 100 ETFs having fees as low as 0.07% (use our ETF screener to find an ETF suitable for you), and the FTSE 100 having a 4.3% yield, retirees may take the view that the stock market could provide income for their future.

It pays to remember that:

  1. dividends can be cut, and
  2. dividends are not a free lunch as when paid the share price of the company falls

The big unknown is at what rate can you safely draw down your pension? It is more than 20 years since William Bengen, a US financial planner, came up with his number of 4% a year inflation-linked. This was based on a balanced portfolio, but nowadays bank deposits and the vast majority of fixed income products yield less than the rate of inflation. If you want 4% a year, inflation-linked, you need to take on significant investment risk.

What if you retired in December 1999 at the peak of the dotcom bubble?

To test a safe withdrawal rate under less than ideal market conditions, we assumed that someone retired in December 1999 at the peak of the dotcom bubble (the UK equity market fell more than 9% a month later) and wanted an RPI inflation-linked income. Coincidentally, December 1999 was 17.8 years ago, more or less matching our average 65-year-old’s expected remaining life.

With a drawdown portfolio, the number one rule — unless you have sufficient home equity, or other sources of income — is that you definitely don’t want to risk running out of capital in 18 years, aged 83.

Since December 1999, RPI inflation has risen by 72%, meaning that someone drawing an initial 4% (or £4000 a year) would now be looking to spend £6880. Our calculation takes this into account, but it does not include fees or any income taxes payable. 

Chart 1: inflation linked drawdown

The graph shows that a 5% inflation-adjusted rate would have led to ruin in 16 years, while someone on 4% would have around £31,000 left in their pot, another four and a half years of income. Similarly, a withdrawal rate of 3.5% leaves £52,000, or 8.6 years of income remaining.

This simulation shows that someone retiring at 65 might have been able to receive a 3.5% inflation-linked income for around 26 years, lasting them until they were 91. Not great compared to today’s annuity rates, and horrible when compared to the c.10% annuity you might have received in 1999.

Nevertheless this was a very bad time to invest. The FTSE 100 was around twice as expensive on a price-to-book measure compared to today, with roughly half the yield.

What if you had some cash as a buffer?

The graph clearly shows that sequencing risk, the order in which your investment returns arrive, is absolutely crucial in determining how long your pension will last. A near 50% drawdown early on, as experienced in the early 2000s, can leave you in extreme peril as you are a forced seller of assets at distressed levels. 

Holding some cash as buffer reduces the prospect of being a forced seller of shares at low priced to fund an income. On the other hand, the more money held in cash, the less chance of growing your overall pension pot.

We decided to test this by supposing that the 3.5% inflation-linked drawdown retiree didn’t go into retirement fully invested, but instead held several years required income on deposit (we assumed there was no return on the investor’s cash).

In 1999, the FTSE 100 yielded 2.3%, therefore dividends in 2009 would have gone roughly 2/3 of the way to replace the cash drawn down on deposit. Only once the initial cash savings and the accrued dividend income have been spent, does the investor need to start dipping into capital.

Chart 2: inflation-linked drawdown with a cash buffer

In this example, holding just two years of cash (£7000) would have been the best strategy, but only marginally more so than starting with five years of cash (£17,500). The investor holding two years of cash ends with a pension value of £68,000 as opposed to £52,000 for an individual holding none.

The graph clearly shows that holding as much as ten years of cash protects on the downside initially, but having too much in cash in a recovery will erode value when the market rebounds.

What does the future hold?

We simply don’t know whether global growth will allow stock markets to continue to make steady gains over the next decade. Interest rates and inflation are low, but they may not be so subdued over the next twenty years.

This makes inflation-linked annuities relatively more attractive to own, even if the initial rate is lower, as a 5% plus inflation rate will quickly reduce your purchasing power. 

Anyone tempted to go down the drawdown route should remember:

  1. Changing your mind is okay. You can still buy an annuity after you have retired
  2. Pound cost averaging can take away some of your initial investment risk, but will not protect you against a large correction further down the line
  3. Fees really matter in drawdown. Low fees could see your investments last several years longer
  4. There are no second chances.  If you have any doubts, speak to a retirement specialist

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