Drawdown as the default retirement option
Falling gilt yields following the EU referendum result in June have pushed annuity rates even further down.
Annuities are a financial instrument used to covert the capital value of a pension pot into a guaranteed income for life.
Before pension freedoms were introduced in April 2015, buying an annuity with a pension pot was the most popular choice for those reaching retirement.
However, pension freedoms combined with falling gilt yields have made drawdown a more popular pension option.
Drawdown is a more flexible approach than buying an annuity with your pension pot; it involves keeping your pension pot invested and withdrawing a combination of tax-free cash and taxable income over time.
According to Alliance Trust Savings, falling 15-year gilt yields causing annuity rates to fall is ultimately making this retirement income option unpalatable and pushing retirees towards income drawdown.
Low interest rates in recent years have also made gilts more attractive than cash, pushing up the price of gilts and reducing their yields.
Following the referendum result in June, 15-year gilt yields fell to an all-time low of 0.9% on 11th August.
One risk associated with income drawdown is the risk that pension pots will run dry during the lifetime of the retiree.
A combination of unsustainably high withdrawals from pension pots and periods of poor investment performance can quickly deplete pension pots in drawdown.
When these factors are combined with the common mistake people make in underestimating how long they will live, there is a real danger drawdown will result in pension pots running out of money too soon.
Brian Davidson, Senior Pension Proposition Manager at Alliance Trust Savings, commented:
“At such low prices, annuities will be unattractive for many more people, with the disadvantage of very low levels of income far outweighing the benefit of income certainty.
“Rates fell further following the Bank of England’s Monetary Policy Committee‘s cut to the base rate of interest at the start of August and, with speculation around a further base rate cut later this year, annuity rate rises seem unlikely.
“A ‘perfect storm’ has been created with the danger being that annuities will simply become unpalatable, resulting in more individuals considering drawdown as the main means of providing a retirement income.
“When considering non annuity based retirement income options though, it is essential that individuals give serious thought to their likely income needs throughout the different stages of their “retirement”, how long they are likely to live and the level of return (after fees and charges) that they need to make on the pension funds that remain invested to meet those needs.
“That will, of course, require a balance to be struck between risk and reward- the essence of all investment decisions. With this many “moving parts” informed advice will be invaluable.”
When it comes to making important decisions about converting your pension pot into an income, seeking professional independent financial advice is essential.
These are lifelong decisions which can have a dramatic impact on your financial health in later life.
Considering all of your retirement income options, including annuity purchase and income drawdown, is a must.