Searching questions: What clients need to ask themselves about retirement income

Redington's Patrick O' Sullivan outlines the key questions retirees should ask themselves before taking retirement income

We are in a new age of increased financial responsibility. At some point, you and I will face a choice between purchasing an annuity or investing and drawing down an income (“drawdown”).

There are some key questions people should ask when making this decision.

What return do I need in ‘drawdown’ to give myself a higher income than an annuity?

The answer to this isn’t straightforward. It also changes with the specific individual’s context and over time.

We can look at a healthy male aged 65 now, choosing between an annuity or drawdown for 10 years before then buying an annuity aged 75.

Based on a pension pot of £100k and a fixed level annuity for a male aged 65, then our calculations indicate that the break-even return I need from my drawdown account is approx. 1.5% over the risk-free rate.

That’s after the administration and fund management fees I need to pay out of my drawdown account.

How can annuity providers afford to pay me a higher income?

Regulators restrict annuity providers to conservative investment strategies. Whatever excess return they generate typically covers their costs and profits.

The genie in the bottle here is mortality pooling. The capital “given up” by those who die earlier benefit the survivors in the pool. This pooling of lives allows annuity providers to give you a 15% higher income when looking over the period between ages 65 and 75 (Based on current UK actuarial tables).

So when we go on our own in a drawdown account, we are effectively playing catch up from the start.

How difficult is 1.5% p.a. over the risk-free rates over a ten year period?

1.5% over the cash rate that currently applies does not sound like a lot. With ten year gilt rates currently 1.6%, this equates to a total return of 3.1%.

It’s not currently possible to achieve that excess return from high-quality assets alone. For example, investment grade corporate bonds only yield an excess return of approximately 1%.

So a portfolio targeting a net excess return of 1.5% requires a significant level of investment risk.

In this context, it is important to remember that in drawdown the sequence of returns matters.

An unfavourable sequence – lower returns early on, higher returns later – can leave you worse off. That’s even if you earn a 1.5% excess return on average over the whole period.

What about the elephant?

The elephant sitting in the middle of the points made so far is the current level of interest rates. What annuity providers price into their annuities is the current market expectation on rates.

You should note that this does include a rise in rates. We can see that the market pricing expects base rates to be 1.75% in three years’ time (source data from Bloomberg).

If you think rates will be a lot higher than this then annuities will be “cheaper” at some stage.

But, if you think that the market expectation is about right, or actually rates might stay lower for longer – then annuities won’t get cheaper.

So what does it really come down to?

If I was making this decision today I would not be choosing drawdown because I expected this option to give me a higher retirement income.

The key for me would be how much value I place on accessing the capital in my drawdown account and/or leaving it behind me if I died. I would judge this relative to the costs and risks associated with this option.

And in costs, I don’t just mean fees. It is a sad prospect, even for me, to think that a lot of time in my later years could be spent on the day-to-day management of a drawdown account.

I hope I end up with the luxury of being able to afford an ok income in retirement through buying an annuity. If I did, I won’t hesitate too long making my choice.

Patrick O’ Sullivan is an investment consultant with Redington