Where's best for pension value?

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The removal last April of the requirement for people in money purchase pension schemes to buy an annuity by the age of 75 has changed the retirement income landscape quite significantly.

Prior to the change of rules, the only way retirees could avoid buying an annuity at that point was to move into an alternatively secured pension, which was effectively a more restrictive form of drawdown with swingeing death taxes. Under the new regime it's both easier and more attractive for those with larger pension pots to leave their pension invested in the markets indefinitely and draw an income directly from it.

The new rules do away with the need to take a minimum amount of income by a specific age, so people can leave their pension funds invested and untouched for as long as they like. They can then adjust and control the level of income they take on a regular basis, according to their changing circumstances.

It all sounds like a good deal for those with larger pension funds who may not need to maximise the income available to them from the outset. But like most pension-related issues, the choice between annuity and drawdown is less clear-cut than it might appear at first.

Importantly, the older you are when you buy an annuity, the bigger the income you're likely to receive, so there's a risk that people who stay too long in income drawdown will lose out after a certain age.

That annuity uplift is partly because those who buy annuities at a later age are increasingly likely to have health problems that qualify them for an 'enhanced' product paying a higher income. But it's also because of 'mortality cross-subsidy' or 'mortality gain', which is the process of pooling the funds of annuity holders who have died relatively early and allocating them to new annuitants, with those most likely to die (because they're older or in poor health) receiving the biggest uplifts.

Mortality drag

The Chartered Insurance Institute's 2010 figures for 'mortality drag' - the extra return your pension fund has to achieve each year to keep up with the impact of mortality gain on lifetime annuities - show that it's only 0.5% a year for those aged 60 to 65, whereas the pension fund of someone aged 70 to 75 has to produce 2.2% of extra yield a year to compete with a conventional annuity yield.

Aston Goodey, sales director at specialist retirement income provider MGM Advantage, explains it another way: "Mortality cross-subsidy becomes increasingly important beyond the age of 70, so for a man with a £100,000 pension pot who buys an annuity paying 7% at the age of 70, the total extra paid over the following 20 years as a result of MCS amounts to £75,900. In effect, it's the amount he'd have lost if he had not had MCS over that time."

The upshot is that, because there is no MCS in income drawdown, the investments of those remaining in drawdown through their 70s and beyond have to work progressively harder to produce a yield that matches annuity income levels, and that means an increasingly high-risk, high-return strategy.

"The opportunity cost of not buying an annuity becomes progressively higher as you get older," observes Steve Patterson, managing director at specialist independent financial adviser Intelligent Pensions.

However, Andrew Melbourne, partner at Square One Financial Planning, says the MCS argument for annuitising is losing ground because annuity rates are low now, and in a low-interest rate environment and with people living longer, they're unlikely to rise.

He says: "Additionally, anyone with ill health now has the option of buying an enhanced annuity, so they are increasingly coming out of the subsidy pool. The more people who do this, the more 'healthy' people are left in the standard annuity pool. The cross-subsidy [from ill people dying early] therefore becomes less with every passing year."

Notwithstanding mortality cross-subsidy arguments, the well-documented downsides of a conventional annuity remain: it offers no income flexibility to respond to changing life circumstances; there is no scope for further growth in the value of your pension fund once you've annuitised; and it dies with you, so nothing will pass to your children after your death.

So how can retirees assess the right route for them as they move through their 70s?

Melbourne describes the decision as "a wealth, health and stealth triangle". It hangs, first, on your need for income from your pension (do you have significant other income-producing investments?) and your taste for risk; second, on how well you are (drawdown could provide more flexibility for surviving spouses); and, third, on whom you'd like to benefit from any remaining funds and how much tax you're willing to pay. "One of these factors will be the most important and will drive the decision," he adds.

For most people, the choice will be fairly straightforward: they need their pension income to support themselves and it therefore makes sense to maximise it. Even some wealthier retirees with other income sources may take a view on the amount of risk they can stomach.

"For anyone averse to investment risk, an annuity is likely to be preferable to income drawdown," points out Kevin Edwards, director at IFA Midland Financial Solutions. The chance of living to extreme old age and exhausting your pension resources is another uncertainty working against drawdown, as is the risk rates will fall further if you postpone buying an annuity for too long, he adds.

However, Paul Garwood, head of personal financial planning at Smith & Williamson, argues that for his largely wealthy client base, drawdown remains the favoured route, despite the MCS argument.

"Annuities are very good for those who cannot afford not to take their pension income," he says. "But most of the people I deal with don't need to draw the maximum income allowed." The big attraction of drawdown for such well-heeled retirees is that they can retain control of their investment pot and (within the prescribed limits) the level of income they draw.

But Garwood emphasises that drawdown is unlikely to be suitable for anyone with less than £200,000 in their pension fund, unless they have other income-producing wealth. "It depends on how much they need to live on and what other resources they have," he explains.

The new rules have opened the way to a more creative approach to retirement income generally. Goodey reports an "explosion" of so-called third-way products that enable people to leave their pension funds invested for longer and adjust their income levels as they need to. These also offer some form of guarantee to the income they draw.

MGM Advantage, for example, has introduced a Flexible Income annuity as a halfway house between annuitisation and drawdown. Alternatively, retirees could opt for a fixed-term five-year annuity.

"That way they have security and the flexibility to get a more appropriate product if their circumstances have changed in five years - but there's no investment growth potential, so it's not very exciting," comments Garwood.

The death benefit discussion

The fact that inheritance benefits disappear on death with an annuity is a major disincentive for some retirees.

However, Aston Goodey points out: "Even with income drawdown, your pension fund will be taxed at 55% on your death once you've started drawing from it. And there is an alternative approach for annuity holders. They can take the maximum income available, on which they'll pay income tax of no more than 50%, and distribute what they don't need on a regular basis to their relatives without any inheritance tax issues arising."

Bridging the gap between drawdown and conventional annuities

The MGM Advantage Flexible Income Annuity (FIA) is aimed at the mass market: with an entry level of just £10,000 it's as accessible as most conventional annuities. But unlike them, it's an asset-backed product: investors mix and match as they wish from a range of seven funds, including both cheap trackers and well-regarded actively managed funds, plus a cash fund.

The aim, says MGM's Aston Goodey, is "to bridge the gap between drawdown and conventional annuities for 70-somethings with an appetite for some risk and also to cater for younger retirees who don't want the risks of full drawdown."

The FIA's big selling point, says Steve Patterson at Intelligent Pensions, is that investors don't miss out on the mortality cross-subsidy boost associated with conventional annuities. They receive a mortality bonus each year, typically of around 1%. On a £200,000 fund yielding 6%, this would mean an annual income of £12,000 boosted by an extra £2,000 each year.

The mortality bonus is funded by the fact that when you die the fund is lost to your estate in the same way as an annuity would be.

But, like income drawdown, the FIA also provides retirees with investment growth potential and income flexibility. MGM Advantage reviews each investor's pension fund every five years and recalculates the income limits according to how much is left. Investors can take between 50% and 120% of the conventional level annuity income that their remaining fund would produce. The income level can be adjusted within those limits each year.

An investor who chooses to take just 50% of the allowable income would have a bigger fund left when the five-year review came around, so higher income limits would be set at that point.

Patterson says this offers an alternative exit strategy to a conventional annuity for investors currently in full drawdown, but that "a phased shift across to conventional annuities is recommended over a period of several years".

Case study: Ian Dunsmore

Ian Dunsmore, 74, a retired solicitor living in Glasgow, and his wife Eileen had been drawing an income directly from his £260,000 pension pot since retiring 13 years ago. "I wanted to be able to protect my pension for the family in due course, and it was working fine, especially as my wife and I have quite a lot of other stockmarket investments, so we're not entirely dependent on pension income," says Ian.

But having realised that his family are doing nicely already and that, now he's in his mid-70s, it makes increasing sense to benefit from age-related annuity uplift in some form, he consulted Intelligent Pensions and has started a phased move into the MGM Advantage FIA.

"I've always been wary of conventional annuities and I'm quite willing to accept some market risk, so this seems a good interim measure," adds Ian. "I'm planning to convert the whole pension pot to conventional or flexible annuities over the next few years; the main thing for me is not to have all my eggs in one basket."

Considering your pension plans? Why not take a look at the range of options available with Interactive Investor SIPPs?