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:
- A 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.
There is a raft of other factors to consider, a significant one being health. But, despite his negativity about the brand, a conventional annuity may well achieve Mr Smith’s objectives better than any other option.
Alistair Cunningham is financial planning director at Wingate Financial Planning.