Published by Kauders Portfolio Management, Authorised and regulated by the Financial Services Authority
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When you turn an individual pension fund into income, there are two basic ways of doing so. The first is to take an annuity for life and the second is to drawdown from the fund.
The annuity route sets future income in tablets of stone, on whatever basis is selected – level or increasing. It gives you certainty (subject only to the mortality of insurance companies, for which there are failsafe and protection mechanisms). Annuity rates are likely to fall even more, since long term bond yields will drop to 1% or 2% as deflationary forces build. But your own mortality means insurance companies may benefit handsomely in event of an early death.
Drawdown avoids the risk of a major capital loss, particularly with larger funds. It works particularly well when the fund is invested in Government securities, so that income and capital are both highly certain. If the pension taken and costs together are no more than the income earned by the fund, then the fund will not shrink as you age. This leaves open the possibility of a better annuity rate for an older person, whether at 75 or otherwise. If drawdown commences in stages, then the tax free cash may even increase compared to the sum taken at an earlier age. However, drawdown is vulnerable to poor investment returns: equity and property investors are, we believe, taking dangerous risks.
If you live a long time, then at present the annuity route may well give a better outturn. But mortality risk has a cost: the risk of a serious loss of capital, and earning less may be an acceptable price for avoiding this risk, even though the capital return may well be taxed in drawdown.
The key is to take investment risk away by holding Government securities. When the two routes can be compared, the costs and benefits of drawdown will become clear.
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© Kauders Portfolio Management 2005