Pension pots and how to survive them

We take a look at a new report from Cass Business School which reviews the best options for looking after Pension pots in retirement.

Pension pots and how to survive them

A new report from the Cass Business School¹ and the International Longevity Centre (ILC) suggests that taking out an annuity at the start of retirement is not a good idea.

Although this conclusion matches our own analysis of the subject (see here), it’s still surprising. We last met the ILC back in April, when we were not impressed by their report boosting annuities at the expense of income drawdown.

Six months on from the pension freedoms introduced in April 2015, the ILC makes clear in its foreword to the new report that although they still like annuities, the public are less keen.

It is clear that since the end of compulsory annuitisation, these products are falling out of favour.

Better late than never.

Pension Freedoms

Historically around 75% of people with a DC pension converted it to an annuity. They provide guaranteed income, removing investment and longevity risk.

Unfortunately, low interest rates and increasing life-spans mean that they are poor value. The typical UK pension pot of £20K would provide an annual income of less than £1K pa at age 55.

The main impacts of this year’s pension changes were: ((Strictly speaking, limited versions of these freedoms were already in place, but the changes formalised the new regime as the standard for the future ))

• the ability to withdraw money from a pension pot at age 55
• the removal of the requirement to annuitise your pension pot
• more responsibility on the individual to manage their money through retirement

Analysis

The report focuses on a retiree aged 65 (and therefore eligible for the state pension) with a pension pot of £100K.

This feels like a compromise to me. It looks as though this scenario may have been cherry-picked to demonstrate a fine balance between the annuity and drawdown options.

I would rather have seen a range of scenarios examined, to cover a wider range of real-life situations:

1. £250K pot at age 55
2. £100K pot at age 65
3. £20K pot at age 65

The analysis looks at total wealth (pension pot plus property plus other assets) but excludes the cost of long-term care. This is mainly because most people can’t afford to fund it themselves – including large pot sizes in the analysis would have allowed this.

Options and decision-making

The report sees three factors as key to an individual’s decision-making process:

1. The risk of living longer than expected and running out of cash
2. Any gift or bequest motive or plans for a major purchase
3. The volatility of (real) investment returns (and tax) in a drawdown strategy

The options are summarised in the table below:

A second table factors in whether an individual is in poor health, is a home owner, or would like to make a bequest:

• Poor health affects longevity and therefore the value for money of an annuity, but may enable qualification for an impaired annuity with enhanced rates, which can give the impression of giving better value for money.
• Homeowners can downsize or use equity release as a source of additional funds.
• The tax-free part of the pot could be passed immediately to children who would benefit more than
  if the money was bequeathed on death (by eg. using it as a deposit on a house); if the retiree lives for seven years, there is no inheritance tax to pay.

For some individuals there will be additional factors:

• a mix of DB and DC pensions
• the size of the DC pot – those with large pots have more flexibility
• age of retirement – those working longer have more flexibility
• couples have more flexibility than individuals

Selection effects and longevity drift

Planning retirement spending requires making an estimate of the expected age of death. Unfortunately this is a moving target.

The expected age of death rises with each year survived, as those who die young drop out of the actuarial equation:

• a man aged 65 can expect to live 19 years (to age 84)
• but by the time he reaches 80, he can expect to live another 9 years (to 89, almost 5 years more than previously expected)

This is known as the selection effect.

A second problem is longevity drift – the general increase in life expectancy over time, from better lifestyles and improved health care.

• So in practice a 65-year-old man should live 21 years rather than 19
• If he survives to 80, his life expectancy will be 11.4 years (to age 91.4, rather than 84 as originally predicted)

Annuities vs drawdown

The analysis ran 5,000 simulations of drawdown, using average real returns of 3% pa, with a standard deviation of 6% per annum. The authors belive this to be representative of a typical mixed  equity / bond portfolio.

The first graph shows the results when the income taken matches that from an annuity (£4,329):

With a £100K starting pot, approximately 25% of pensioners run out of money after 30 years.

The letters on the chart show three versions of a deferred annuity purchase strategy:

• at age 75 (point A), the median value of the pot would be worth £83,139 which would buy an
  annuity worth £5,371 pa
• by age 85 (B) it will be worth £60,557 and buy an annuity worth £6,729
• by age 95 (C) it will be worth £30,738 and buy an annuity worth £8,110

So deferring an annuity purchase will on average be advantageous.

The next chart shows the probability of the pot running out by a given age:

Almost everybody can last for 20 years by withdrawing the same amount as an annuity, and even after 25 years the failure rate is only 7%.

• This represents the age of 90, by which time 58% of men will have died already.

Unsurprisingly, choosing more aggressive rates of withdrawal increases the risk of running out of money:

Flexible drawdown and the SWR

As we have seen previously, fixed withdrawals can have serious impacts after market falls – this is known as pound cost ravaging.

The report therefore recommends that income drawdown is varied to reflect the size of the pot remaining. A simple version of this strategy would be to withdraw a fixed percentage each year.

Many drawdown fans will have reached this conclusion independently. There is much discussion of what constitutes a safe withdrawal rate (SWR) amongst those working towards financial independence.

Using the drift adjusted life expectancy for a 65-year-old man of 21.9 years, the SWR can be estimated as follows:

SWR = 100% / 21.9 = 4.6%

This calculation can be repeated each year using the remaining pot size and a new life expectancy estimate.

I would argue that 4.6% is quite an aggressive SWR, and most retirees would do better to start at around 4% pa and observe whether the size of their pot increases of decreases.

The table below reflects the report’s version of flexible drawdown:

The average retiree would be able to withdraw more than the annuity level until the age of 89.

Bequeathing wealth

The report also looked at the opportunity provided by drawdown to bequeath wealth.  Not surprisingly, the lower the income taken during drawdown, the more wealth can be passed on:

Conclusions

The report has quite a long list of conclusions. Emphasis and comments below are mine.

1. people are living longer
2. annuity rates are at historic lows and this is likely to continue
   • the new uni-sex rates are particularly unattractive for men, who die younger than women
3. those dying young waste money by annuitising early, as annuities are irrevocable and the annuity dies with you
   • the risk is lower for those eligible for impaired life annuities
4. inflation protection in annuities is expensive and those who take a level annuity early will find its value erodes during their retirement
5. those with small pension pots will receive a small income from an annuity which may nevertheless impact their benefit entitlement
6. most people are better off drawing down than annuitising (we knew this already)
   • drawdown provides the flexibility to find money for unexpected emergencies, or to fund bequests
   • moderate sized pension pots (£100K or more) should not run out until at least the age of 80
   • using a flexible rather than fixed drawdown approach can reduce the risk of running out still further
   • those with large pots should always use drawdown
   • those with property (which provides additional security) and / or a bequest motive will prefer drawdown
   • those with pots around £100K face a difficult choice
7. using the tax-free lumps sump to top up your state pension entitlement is (for those with less than a full state pension) better value than an annuity
8. annuities are more attractive at older ages to protect against longevity risk
   • this is particularly the case if there is no bequest motive, for single / widowed people, and for those not owning property
   • they are better value because of the `mortality credit’ or ‘dead pool’ effect
9. those with property should consider equity release / downsizing if their pot begins to run out
10. the vast majority of people don’t have large enough pension pots to provide for both an annual income and the cost of long-term care²
11. annuities could be made attractive again by loosening the requirements on investment strategies to introduce with-profits products
12. the report recommends a financial `health check’ on retirement, followed by regular reviews throughout the period of drawdown
    • this is backside-covering advice that will be too expensive to implement for the majority of retirees with small pots – free education and advice needs to be provided instead

It’s good to see an industry report that finally acknowledges the elephant in the room.

• For a variety of reasons, annuities don’t work any more.
• The challenge for the investment industry is to handle the transition to drawdown.

Until next time.

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1. coincidentally where I did my MBA [↩]
2. The median pot is around £20K [↩]