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Annuity is still the way to go for risk-averse pair

by Alistair Cunningham on Dec 07, 2012 at 14:06

Annuity is still the way to go for risk-averse pair

Mr Smith, 65, is a retired bus driver and his wife, 62, is a retired teacher. He has a pension fund of £100,000 after their pension commencement lump sum. They have inflation-linked private and state pensions of £15,000 and would like £20,000 per annum. They have described themselves as ‘cautious’ and have no wish for index-linking, preferring the maximum now. Mr Smith does not like annuities because his friend, Mr Brown, died shortly after setting one up.

Researching the market, they have two options:

  • Annuity: £5,400 per annum, which would include a 50% spouse’s pension if Mr Smith pre-deceases Mrs Smith.
  • Drawdown: £5,300 per annum, which represents 100% of the Government Actuary’s Department (GAD) rate.

Alternatively, they could consider:

  • fixed-term annuity of £5,300 per annum, with a guaranteed maturity value in five years’ time of £78,000.
  • A ‘guaranteed’ drawdown of £5,300 per annum, which may decrease but not below a promise of £4,000.

With a fixed-term annuity, if rates do not improve (or worsen), Mr Smith will be able to secure £4,700 per annum in five years’ time. Effectively, he has not achieved more at the outset than the level annuity and he has increased the uncertainty in five years’ time.

The guaranteed drawdown would seem to offer a worse downside level of income, but arguably a lower chance of this happening.

Factoring in fees

The cost of advice is another factor. The annuity is a once-only decision and so is likely to involve lower lifetime costs than the other options. The simpler investment choices on the fixed-term annuity and guaranteed drawdown are not necessarily cheaper than full drawdown due to the competitiveness of the market. Guarantees add significantly to the cost of guaranteed drawdown.

Most advisers have risk-adverse clients with strong opinions against annuitising. However, while drawdown also has significant risks, for most clients so-called third way options have the disadvantages of both annuities and drawdown.

One of the most significant benefits and drawbacks of an annuity is its provision of a guarantee. That means that worsening health or the loss of spouse do not improve the rate, but then falling gilt yields and increasing insurer solvency margins do not worsen the rate.

Fixed-term and investment-linked annuities, along with guaranteed drawdown, have tried to plug the gap, as illustrated by my example. I struggle to see how a right-minded couple would choose anything other than one of the two polar extremes.

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9 comments so far. Why not have your say?

James Dean

Dec 07, 2012 at 14:47

I think this is an excellent article that illustrates the fact that there is no clear, black &white decision on where one solution is better than another.

If it comes down to getting the maximum (and secure) income out of a pension fund over a lifetime, then an annuity is hard to beat. If the client is looking for flexibility over a number of options and death benefits, then the various alternatives offer some potential solutions.

However without both the capacity for loss of some future income or an acceptance of some degree of investment risk, then it really does have to be a conventional annuity....whether they like the rates and inflexibility or not!

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steve smith 2

Dec 07, 2012 at 15:18

And what about inflation? And that based on average life expectancy Mr Smith will not even get all his fund back with an annuity! Great recommendation!

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Dec 07, 2012 at 15:43

can't really say what is right without looking at the clients health. my big bug bear with annuities though is if you are looking at an income of £5,400, if you were able to run your fund down to nothing, even with today's deposit rates of say 3.5% - 3.75%, a pot of 100K would last 30 odd years even with 1.5% pa charges. And lets be honest, interest rates aren't going to stay at 0.5% for 30 years! I think that is why people don't like annuities, because the instinctively feel really bad value for money (and usually are unless the clients in ill health)....

have said that, if a client hasn't got any other source of income, then I would usually say that certainty is more important than anything else...

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Dec 07, 2012 at 16:03

Presumably, they had some pressing need for the full tax free cash, otherwise they are good candidates for a phased drawdown solution using annuities.

This would be tax efficient and would get round his fear of annuities.

Steve Smith: you are wrong. Read the article again.

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Gas boy

Dec 07, 2012 at 16:19

And what about if Mrs Smith pre-deceases Mr Smith? A very good reason to consider a fixed term plan?

How relevant are enhanced annuities to this situation as well?

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James Dean

Dec 07, 2012 at 16:22

The comments so far, illustrate my own comment well that there are so many variations on a theme that it is difficult to favour only one.

For those open to seeking an alternative, they really do need advice....thankfully

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Eamonn Dorling

Dec 08, 2012 at 09:16

James makes the key point. Advice from a professional plus all the administration being efficiently dealt with makes a fair fee really good value for money.

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Andy Heath

Dec 10, 2012 at 08:45

Bearing in mind up to half of us are likely to experience a life-limiting illness between 65 and 75, this alters the downside risk of a short-term annuity. And since more than half (not necessarily the same half!) are going to die before 80 [2011 figures for England & Wales], most of us won't do all that well out of a lifetime annuity.

Merry Christmas, everybody!

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Barney Stackhouse

Dec 10, 2012 at 08:50

Some of the things people miss with pensions are:

Look at the total amount paid in to the original arrangement after tax relief.

Then subtract the the tax free cash (which is effectively a return of a proportion of the contributions paid) which will give you the net capital invested.

Express the income produced by the annuity as a percentage of the net capital actually invested - all of a sudden you are getting the equivalent of 7% or 8% plus as a yearly guaranteed income for life - with no risk!

In the example above, there is a 50% spouses benefit included, I would also recommend looking at the very slight reduction involved in adding a 10 yr guarantee to the initial level annuity. This usually only reduces the initial annuity fractionally but gives a sense of security to the income for the first 10 yrs.

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