Drawdown versus annuities: income or security?

Many have suggested that longevity and other factors have hamstrung pricing to such an extent that advisers should focus their attention not on the malfunctioning open market option but on a different market altogther: income drawdown.

Is it simply fashionable to trash-talk annuities? Well, if the Financial Conduct Authority recent wading-in is anything to go by, then there are serious systematic problems in the annuities market, especially for savers with smaller pots.

The FCA’s thematic review, which itself resulted in the launch of another ‘competition’ review, seems to have been the spark setting alight kindling which has, to stretch a metaphor, been drying out for quite a long time.

Commentators have warned that savers could be unwittingly forking over thousands of pounds to brokers taking as much as as six per cent commission in some cases, while parliamentarians have begun to sound the alarm over annuities being the ‘focal point’ of the next mis-selling scandal.

This all plays out against a background of prolonged lacklustre annuity rates, due in large part to persistently rock-bottom interest rates and predicted by some to stay low for the next three years.

Tom McPhail, head of pensions research at Hargreaves Lansdown, points out that annuities have been heading south for a decade, although have showed slight recovery recently.

“Rates have collapsed, from around 7.5 per cent for a 65-year old in 2004, to around 6 per cent today; this is after recovering from a low point of around 5.5 per cent at the end of last year.”

Mr McPhail said this persistence in low rates had “undoubtedly” increased interest in drawdown for some and potentially even for a large proportion of the advised client base. Sales numbers, however, remain “relatively low”.

In January of this year, pensions tech provider Selectapension published data suggesting advisers had seen a 160 per cent rise in drawdown enquiries over the previous two years, and a 24 per cent increase in the previous two months alone.

In one firm’s case this had seemingly translated into sales too: in November of last year Skandia reported that drawdown business on its platform pension, the Collective Retirement Account, was up 200 per cent over twelve months.

The case for drawdown

For an increasing number of those with a significant retirement pot drawdown may well be a preferable option, argues certified and chartered financial planner Alan Dick, owner of Glasgow advice firm Forty Two Wealth Management.

Mr Dick estimates that more drawdown accounts for than four-fifths of the retirement business he writes. For the record, most of his clients have pension funds of more than half a million pounds.

“The ability to alter income each year to maximise tax efficiency is attractive. Several of our clients want to access their tax-free lump sum to fund some other business or investment project but don’t want to increase taxable income at this stage.

“Another big attraction is the flexibility of death benefits. Most clients are averse to losing all, or a large portion of, their fund on early death.”

When determining if drawdown is the route to take, Mr Dick weighs the need for flexibility against that for security, and looks at what other options are available.

“Drawdown clients need to have sufficient funds invested to cover the costs, including the cost of our advice. They also need to be able to afford to take investment risk – capacity for loss – which can be identified from their lifetime cashflow forecast among other things.

“They need to be emotionally able to deal with the ups and downs of markets and also be able to reduce income for a few years if investment markets hit a rough patch.”

Is there a middle road?

It’s all well and good pointing out how effective drawdown may be for wealthier clients, but don’t forget: the FCA warned us that it’s those with smaller pots who suffer the most from exorbitant fees and the perceived failures of the annuities industry.

So it would appear that clients with less to invest are, as usual, stuck in a rut. They can’t secure the income they need from an annuity – far from it – and yet their assets are too small to take advantage of drawdown.

Mike Morrison, head of platform marketing at AJ Bell, says a third way is becoming ever more necessary.

The crux of the problem is this: drawdown carries too much risk for most with modest pots and annuities present too little income potential.

“It isn’t that annuities are poor value, it’s that retirement has changed. If you are 60 and you don’t want to lock into a poor annuity rate and don’t want the risks of drawdown, there needs to be an option that de-risks drawdown.”

“In the old days you did drawdown as a short-term measure before you bought an annuity. If you were 55 or 60 you might go into drawdown for four or five years and then buy into the certainty of an annuity.”

Mr Morrison said this remains an option but that the deferment was likely to be longer nowadays, saying he sees “no reason why anyone would want to buy an annuity before their late sixties”, or even later.

However, he adds that this approach is best suited for middle-sized pots of £300,000-£400,000, so it might not be the best solution for those with smaller pots who can barely afford any risk at all.

For those with less than this he said he would like to see the development of a new type of drawdown product, which uses an investment solution that sufficiently de-risks drawdown to make it suitable for investors with less capacity for loss.

Obviously, there are annuities options in this ‘third way’ space, that provide a guaranteed minimum income but remain partially invested and can provide significantly more income than conventional peers.

Mr Dick sums up the popular attitude to these options, however: “I have looked at the so-called third way investment annuities. Call me stupid but they look like the worst features of annuities and drawdown in most cases so we have yet to use one.”

Update: In this year’s Budget, changes were made that changed the annuities and drawdown market meaning further reading will be necessary.