I remember an occasion in the early 1990s when one of our direct sales people had been caught running a Ponzi scheme and generating commission of a quarter of a million, and my chief executive throwing a tantrum at the ridiculous rates of commission we were paying our salesmen.
I told him that the average amount of commission our direct sales people earned was around £14,000 and there were no perks. He turned round to me and said: “I don’t believe you.”
When I said I was sure, he said with complete incredulity: “How can anyone live on that income?”
I was reminded of that episode when the chancellor decided that people did not have to buy an annuity with their pension monies.
An Etonian PM and a St Paul’s School-educated chancellor can have no conception of what it is really like for the common folk.
They have more money than they can use. Ordinary folk often have too much life at the end of their money; if they are prudent they may go the other way and have too much money left over at the end of their life. They could have lived better. An annuity guarantees an income to the end of your life and you can then match your expenditure to it.
Income drawdown is seductive but it has its drawbacks. To illustrate this consider a man aged 65 about to give up gainful employment. The year is 2020. He is looking to have a regular income to cover his outgoings which, monthly, are as follows;
Housing £400 House paid for. Rates, utilities and maintenance
Food £600 Him and his wife.
Recreation/holidays£600 Pub/gym/clothes/holidays etc.
Car £200 Petrol, service, tax, depreciation
£1,800 Equivalent to £24,500 gross
That is, £21,600 a year net or £24,500 gross. The 65 year old would get a basic state pension of £155/week, £8,060 a year so he needs to find another £16,440 a year. He could buy an annuity and insulate himself against longevity.
I have constructed a mortality table. It is a simple model to make my calculations internally coherent. Assuming that the insurer earns an interest rate of 3 per cent a year and ignoring profit and expenses, to buy a lifetime fixed income of £16,440 a year, he would need a purchase money of £257,000. If he wanted it to increase at 2 per cent a year, the assumed rate of future inflation, he would have to find £319,000. He chooses the former.
Now let us assume that instead he invests the money to earn the same 3 per cent yearly rate and does an income drawdown of £16,440 a year, so that his annual income is the same as if he had purchased an annuity. He is self-insuring the longevity risk.
At some stage in the future he would have to lay it off. Table 1 shows the options available to him:
Table 1
| Age | Fund remaining | The annuity it will buy | Total income | Income shortfall: annual | Income shortfall: monthly |
| 75 | £156,000 | £14,370 | £22,430 | £2,070 | £170 |
| 80 | £94,000 | £10,550 | £18,610 | £5,890 | £490 |
| 85 | £22,000 | £2,940 | £11,000 | £13,500 | £1,125 |
| 87 | Insufficient funds | Insufficient funds | £8,060 | £16,440 | £1,370 |
If he waits until he is 80 before buying an annuity, his monthly income would drop by £490. He would have to adjust; perhaps spend £90 less on food and cut down the holidays and recreation cost by two-thirds. If he leaves it until he is 85 then he is stuffed as his monthly income would drop by £1,125. Remember in all this we are ignoring (a) inflation and (b) additional healthcare costs.
Of course the idea is that the pensioner might achieve more than 3 per cent a year. He might; on the other hand he might not. Are we saying that he can do better than the professionals? Let us assume that he is gifted and earns 4 per cent a year after any tax payable, but annuities can only be purchased at 3 per cent a year. Table 2 shows the options available to him:
Table 2
| Age | Fund remaining | The annuity it will buy | Total income | Income shortfall: annual | Income shortfall: monthly |
| 75 | £182,000 | £16,770 | £24,830 | £330 (gain) | £28 (gain) |
| 80 | £133,000 | £14,920 | £22,980 | £1,520 | £125 |
| 85 | £72,700 | £9,860 | £17,920 | £6,500 | £540 |
| 87 | £45,000 | £6,600 | £14,660 | £9,840 | £820 |
| 90 | Insufficient funds | Insufficient funds | £8,060 | £16,440 | £1,370 |
He is actually better off if he delays buying an annuity until he is 75 and can probably leave it until age 76 or 77. The reason is that he obtains a 1 per cent extra yield on his investment whereas the mortality rate in my model is under 1 per cent below age 70. It climbs to 2.5 per cent by age 75 so it is not surprising that it changes soon after.
He still runs out of funds, but later. How confident can he be that he will get superior investment returns? Remember, with drawdown, the risk to the monthly income is asymmetrical; he loses more on under-performance than he gains on outperformance. Pound-cost averaging works in reverse when you are disinvesting.
It is the rump of the population that is most vulnerable, the so-called middle-UK, those earning between £10,000 and £50,000. Those who earn more can be left to their own devices; those who earn less would not have a major adjustment if they have to rely on the state pension. Life might be grim but they cannot expect to be better off when retired than while they worked. At any rate it is a social problem not a pension problem.
What we are saying is that while we can allow those earning over £50,000 to do what they want but that those earning less must buy an annuity. It is not easy to frame a practical rule. Perhaps it should be a rule such as: “The first £300,000 of your pension pot must be used to buy an annuity.” That would catch those earning over £50,000 as well but what the heck.
We can take this one stage further. If the pot in excess of £300,000 can be taken in any form, then why not call the excess an Isa?
Basically, pensioners have two savings outlets: a pension arrangement in which you put tax deductible contributions and it rolls up tax free but is then taxed when taken as income. You also have an Isa in which contributions do not attract tax relief but rolls up gross and can be withdrawn without tax being payable. The former cannot be accessed before age 60; the latter is always accessible.
There are practical problems in policing the £300,000 limit. It may be that, there will be contribution limits and if the £300,000 is still exceeded because of outperformance then the excess will have to be taxed.
Having made a case for buying annuities, there is a case for not buying it just yet. Gilt yields are depressed because of the government’s quantitative easing programme. It is a good 2 percentage points off where it should be. At some stage it should revert to normality. I am not suggesting to the reader to hold off for a couple of years. That would be giving investment advice, which I am not authorised to do, but if I were in that position that is what I would do.
Icki Iqbal is a former director of Deloitte
Key points
* Income drawdown is seductive but it has its drawbacks.
* Under the first calculation, if the saver waits until he is 80 before buying an annuity, his monthly income would drop by £490.
* Basically pensioners have two savings outlets: a pension arrangement and an Isa.
