The perils and pitfalls of pension drawdown

Former Chancellor George Osborne has played on their already negative image: “Let me be clear. No one will have to buy an annuity.”

And yet annuities deliver a guaranteed income stream for the rest of the annuitant’s life. Those are two huge positives. So why not buy one?

The short answer is the well-documented decline of annuity conversion rates. People do not think they are getting good value. What is possibly less obvious to them is that there are good reasons for this decline, and it is not just about interest rates or annuity company profits.

Interest rates are, of course, a major factor and we are currently in a very low interest environment, which does not look like changing much in the near future. However, another key factor is increasing longevity, and this looks even less likely to change. Put simply, the longer an income has to last, the lower it will be across the period as a whole. 

For these reasons my opinion is that anyone looking for an immediate and guaranteed income for the rest of their lives would probably be better off purchasing an annuity at outset rather than waiting for rates to improve. There is no indication that they will and, even if they do, it may not be by enough to provide the income they want later.

In the absence of any other reason to delay or avoid annuity purchase, these individuals are the wrong people to be using drawdown. If the income they can receive from an annuity is too low to meet their needs they should probably be looking for other ways to supplement or improve it.

Income issue

It is often assumed – not least by the Regulator – that drawdown and annuity customers have similar income objectives. However, in 2016, 80 per cent of new customers at one life office used drawdown to access only the pension commencement lump sum (PCLS).

Where regular income is required, then the drawdown annuity comparison is not only valid, but necessary. Where it is not an annuity is arguably irrelevant, the decision is about whether it is a good idea at that time for the individual to take any money at all.

With increasing life expectancy it is not unlikely that some individuals will spend 30 or more years in retirement and the likelihood of the income needs remaining the same over such an extended period is minimal.

Some of these changes can be predicted and insured against – for example the effect of inflation. Others potential changes include the period over which they will remain healthy and active. Income drawdown provides the ultimate flexibility to withdraw additional income when it is required. 

Death benefits

Drawdown still has the edge over annuities for those who would like to pass on any unspent pension money to their family after their death. Although there are more and better options available under modern annuity contracts, ultimately any death benefits would be assessable for tax.

Under drawdown, any lump sum benefits paid out on death before the age of 75 will almost certainly be tax-free; any income or lump sums paid out on death after that age will be subject to a tax charge. However, there is the considerable advantage that the beneficiary does not have to withdraw the money and any remaining funds can be passed on again in the event of their subsequent death.

Financial advice

What should not be overlooked is the need to manage the customer’s investments and the level of income they are withdrawing. Financial advice is an essential element in this. 

In the absence of Government Actuary's Department (GAD) rates, which, while not perfect, did at least provide a ball park figure for the likely sustainability of income, someone needs to assess how much can be taken without the danger of running out of money too soon. The average drawdown investor is unlikely to have the knowledge and skills to do this themselves. 

Fiona Tait is a pensions specialist of Royal London

Key points

Most people still favour a secure income over flexibility of income in retirement.

With increasing life expectancy it is not unlikely that some individuals will spend 30 or more years in retirement.

Under drawdown any lump sum benefits paid out on death before the age of 75 will almost certainly be tax-free.