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
Charges
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
Performance
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.
Mortality Drag
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.
Summary
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.
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