Annuities vs Drawdown Retirement Income

Most of life’s routine expenses—mortgage payments, electric bills, etc.—must be paid monthly, and there is a need for a guaranteed income that can cover those expenses. 

Yet, retirees generally respond unfavorably to financial products that offer substantial protection and guarantees.  If a product offers a future stream of income or can cushion retirees against a large drop in the stock market, they may not buy it if they can’t withdraw their money whenever they want.   

This is where “loss-aversion” can inhibit their ability to make what we believe would be more sensible financial decisions.

The main two ways people take their income are through an annuity and through a drawdown plan; here we look at the pros and cons of these two methods of drawing on your pension. It is also possible to split your fund between the different options and to phase the purchase of an annuity.

Annuities

An annuity is a consumption plan that guarantees lifetime income.  If you’re planning for retirement, leaving a position and rolling your pension or 401(k) or simply want to start a safe secure investment, you’ll find the fixed annuity is perfect for your situation.

A fixed annuity can be an IRA, pension, 403(b), 401(k) or rollover IRA, which makes the product a qualified annuity. Qualified annuities and non-qualified annuities can be the same product. The difference between the two is the paperwork used to identify that the government recognizes its pension money, and therefore gets special tax consideration.

Immediate annuities provide a series of payments until the client dies, this is also known as a pension.  Annuities are offered by insurance companies and pay you a guaranteed income for life in exchange for your pension pot.

For example, if a retired couple needs $4,000 per month to cover their living expenses, and Social Security and pensions provide $3,000 per month, they could purchase an annuity that would pay out the needed $1,000 per month for as long as either one of them lived.

You purchase the fixed annuity and at the end of one payment period, you receive your first check from the insurance company. Of course today, most people have the income directly deposited into their checking or bank account to avoid the hassle of taking a check to the bank or the worry of someone stealing the check from their mail

This income is taxable. They’re secure and simple. Yet people often buy them begrudgingly. The over-riding reason for this is that if you buy a single life annuity with no guarantee (which many people do), then when you die the income stops.

People tend to think of this negatively because if you die three years after buying such an annuity then your income stops and your pension pot is gone.

This is true, but there is a flip side to this coin: if you live to 100 your annuity will still be paying you a regular income year in year out.

You might be pleasantly surprised by how long you can expect to live. On average, a 65 year old man can expect to live until his 86th birthday and a 65 year old woman until her 89th birthday. Those are just averages- healthier people can expect to live even longer.

If you don’t like the idea of your annuity dying with you, you can opt for a spouse’s pension or for a guarantee period. Adding such options onto your annuity will tend to reduce the starting income you get from the annuity, but it will also mean your pension income could continue to a spouse or to your estate after you die.

Basically because you are statistically more likely to die earlier if you are in poor health or smoke, some competitive annuity providers are willing to give you a higher income because they don’t expect to have to pay out for so long.

Income drawdown

Investment returns, are typically irregular and feel more abstract with regard to expenses. A drawdown plan is very different to an annuity. Instead of handing your pension over to an insurance company in exchange for an income, you continue to keep your pension fund invested. You can then draw whatever income from the fund you wish, subject to a maximum set by the government. As with an annuity this income is taxable.

Unlike an annuity your income is not secure so it’s value could go up or down depending on how well your investments do.

Risks associated with this concept will remain a concern as poor investment performance or large income withdrawals can quickly erode your fund’s value and it is unlikely you will continue working while drawing an income, in which case you will not be able to make up any shortfall.

You do have the flexibility to alter your income to fit in with your expenditure and your other income. There is also the possibility your income could rise if your investments do well.

Drawdown is therefore riskier than an annuity, but is also more flexible. It’s generally more popular amongst investors with bigger pension pots who are willing to take investment risk and are prepared to accept the possibility their retirement income may fall, or even run out altogether.

 You will also have to continue to manage your pension if you go into drawdown, or employ an adviser to manage it for you. Although we strongly suggest you seek advice as it is a more complex option. If you have decided to go into drawdown make sure you don’t end up paying extortionate fees.

Some drawdown providers charge many hundreds if not thousands of pounds a year, which can have a significant effect on your fund size and hence your income.

Eliminating or reducing the chance of default in the portion of a retiree’s assets that provides their basic living expenses can alleviate loss-aversion. Once retirees’ essential spending needs are taken care of, they may feel better about pursuing higher returns with the rest of their savings.

Fixed Index Annuities

A Fixed Index Annuity (also equity-indexed annuity) is a special type of fixed annuity contract that fuses the safety of fixed annuities with higher participation in the financial market. Strictly speaking, it is not an investment- as it is primarily an annuity contract between an annuity investor and insurer or annuity provider. Although Fixed Index Annuities represent an improvement on fixed rate annuities, they inevitably have their merits and demerits.

Guarantees

Fixed Index Annuities- like other insurance contracts- offer investors guarantees on their premiums and returns. Indexed annuities have a rate tied to a financial market index, typically an equity-market index like Standard & Poor’s 500 index of stocks.

The advantages of the indexed annuities are potentially an average return higher than fixed annuities or fixed-income assets, a risk reduction factor that allows the investor to give up higher returns in exchange for a return minimum guarantee, reducing the variance of returns on both the high and the low end.

Apart from safety assurances for contributions, Fixed Index Annuities offer investors minimum (base) guaranteed rates of return. This suggests that even though their performance is linked to an external index, the annuities are insulated from severe downturns in the market.

In conclusion: A major benefit of equity-indexed annuities is that they offer returns that link to market performance through an external index (such as the S&P 500). Annuity investors on this plan can benefit from favorable fluctuations in the market while being insulated from sharp downturns. Fixed Index Annuities also offer higher returns than fixed rate annuities, CDs and Money Market Funds.