Risks Associated with Pension Drawdown
Pension Drawdown is a complicated subject that must be carefully considered. It comes with risks which should not be underestimated. For the right person, with alternative sources of income, that understands and accepts the risks associated with pension drawdown it could be an excellent alternative to annuity purchase. Annuities-Online can provide further information and advice for pension drawdown products.
Essentially, the risks are charges, performance, future annuity rates and mortality drag
You existing pension may not have a pension drawdown facility, in which case you may need to change the terms of your pension. It makes sense to consider pension drawdown contracts from other pension providers. An Independent Financial Adviser will be best placed to research the market and advise on the best pension drawdown provider for you. Clearly, this work will involve costs but the benefit of selecting the right drawdown contract should outweigh the costs.
The overall ongoing charges for drawdown contracts tend to be higher than ordinary pensions. Also, once income commences there may be an annual charge in the region of £400. These charges make small pension funds uneconomical for pension drawdown
Eventually, you may have to purchase an annuity and the size of the remaining pension fund will dictate how much income you will receive thereafter. If your pension fund has reduced significantly as result of income withdrawals and poor performance then the income available from an annuity may be much less than you would otherwise have achieved had you simply bought the annuity in the first place. However, if investment performance is good then your future income could exceed what you would otherwise have achieved through a conventional annuity. As you know, investment returns cannot be guaranteed, so make sure you understand the consequences of underperformance. We have a calculator that can help with this
Future Annuity Rates
Increased life expectancy erodes annuity rates; a pot of money provides income and if the payment period increases then the series of payments must reduce. Annuity returns are linked to gilt rates, which have fallen considerably over the last few years – this trend should eventually reverse as gilt rates rise to their longer term average. To give you some idea of the problem, 15 year gilt rates were c4.5% during spring 2008 but by Autumn 2011 they were c2.6%.
What is likely to happen to future annuity rates? Our calculations show that if the gilt rates used by annuity provider increases by 1% then income would increase 7.6%. If life expectancy was to increase by 2 years then annuity rates would fall by 5.6%. It is more likely that gilt rates will increase by 1% before life expectancy increases by 2 years, so in the medium-term we would expect annuity rates to increase. In the short-term they could fall a little further.
Deferring an annuity may result in achieving greater income but there is no guarantee.
Conventional annuities offer a cross subsidy between those people that die earlier than expected and those that live longer than expected. If you enter into an annuity pool later then you will not benefit from the cross subsidy from those people who died before you. To overcome this a pension fund must grow by a little more to provide the additional income to make up the shortfall that would not have occurred if the annuity was purchased earlier.
For pension drawdown to offer better value than a conventional annuity you may need to achieve an underlying investment return in the region of 7%pa after charges but this will depend on the level of income you take. The exact amount will depend on a number of factors, in particular the size of your pension; smaller pensions may have to exceed this rate of return.
Always seek professional advice to help you fully understand the risks associated with pension drawdown.