What price certainty? (Boring blog on annuities and drawdown)

price of certainty.jpeg

In financial matters, certainty comes at a price. Is it a price that I’m prepared to pay?

I’ve been putting myself in the shoes of a friend who is around the same age as me (57) and is hoping to put his feet up and quite literally STOP WORKING. Knowing this person, not working will mean working as hard as ever but she does not want to have to charge others for what she likes to do for free and besides she has a healthy financial outlook.

She’s married to a man who is independently wealthy and she’s worked for most of her life in a job which was pensions. She has what she feels is the certainty of a defined benefit pension of £22,400 today or £32,000 if she waits for it to start till she is 62 and she has around £186,000 in a personal pension.

Shocked by the actuarial reduction!

Although the actuarial reduction on her DB plan is only 5% pa, my friend considers this a rip off! I’ve explained that her £22,400 could be revalued up towards £32,000 if there is plenty of inflation in the next five years, she’s having none of that “if”! She wants the certainty of a pension for life and has worked out that she’s likely to live a long time. So she has dismissed the idea of taking her actuarially reduced pension today.

I’m not sure she’s right but she is taking a view on her durability and as she pointed out to me “I need a financial incentive to stay on the planet – my pension is the only one I’ll have!”


Bridging the pension gap

The problem with waiting till she’s 62 is bridging the gap between now and then. She asked me whether she could get a certain pension just for those five years and I asked my helpful friends at Retirement Line.

If she wants a certain pension these are her options.

Tax Free Cash £46,500   Fund Value – £139,500   
TermIncomeGuaranteed    Maturity Amount
8 years (to age 65)£18,058.44 pa£0
13 years (to age 70)£11,543.52 pa£0
18 years (to age 75)£8,846.16 PA£0
5 Years (if he waits to age 62)£22,500£29,529.00
5 Years (if he waits to age 62)£28,141.44£0
   
   
   
FV – £186,000  
TermIncomeGMA
8 years (to age 65)£24,171.36£0
13 years (to age 70)£15,446.88£0
18 years (to age 75)£11,840.52£0
5 Years (if he waits to age 62)£22,500£78,372.00
5 Years (if he waits to age 62)£37,643.04£0

We’ve discussed all the greyed out options which have been discarded. What my friend is interested in is that she can have an income of getting on for £38,000 pa certain or just over £28,000 with the flexibility to dive into £46,500 for special purposes.

What appeals to her about a fixed term annuity (which I’ve told her will earn Retirement Line £1,500)  is that she will get a monthly deposit in her bank account and that she can get on doing what she wants to do knowing that she is independent of her husband’s income. These simple emotional pleasures mean a lot to her


The opportunity cost of certainty

We have also looked at two types of income drawdown, one would involve investing all her £186,000 and taking an income. Here she can take advantage of a tax break from UFLMPS which she really likes (she refers to UFLMPS as FLUMPS).

Under FLUMPS she can set an income level for herself and have it paid to her 75% taxed and 25% tax-free, I’ve explained she’s taking her tax-free cash as she goes along.

I’ve explained that even if she put all her money in cash , she is more likely (even with added charges) to do better than with a fixed annuity for the whole sum (the £37,600 one).  This is just down to tax.

We’ve discussed how much risk she’d be happy to dial-up to get herself more income and the answer’s “not much!”.

So for her, the opportunity cost of certainty is not very high at all and she’s now weighing up whether she wants her tax free cash up front and a fixed term annuity of £28,141 or an UFLMS drawdown with money held in income paying deposits.


Benchmarking against certainty

I’m not a financial planner, I’m certainly not an investment expert and the lady will – if she goes the UFLMPS route, implement with the help of a financial adviser. Retirement Line will implement if she buys an annuity and they’ve been upfront with my friend that the £1500 commission will only be paid on execution of her annuity – there will be no fees for the help we’ve got from them.

We’ve put together a simple spreadsheet which allows her to work out how much income she could drawdown ( net and gross) and we’ve factored in the extra costs of product and advice (which are integrated in the annuity rate).


See you in five years time!

I’ll leave her to decision. I’ve told her to come back and talk to me in five years time about how much of the tax-free cash she needs to take from her final salary pension . That £32,500 comes with a big fat tax-free- cash sum of £215,000.

Having objected to her actuarial early retirement factors, she may well choke at the conversion factors on her tax-free cash. When she compares the cost of buying an annuity with the lost pension from taking cash, I suspect she’s going to think twice of taking the cash (tax-free or not).

And of course – there’s also the little issue of valuing her pension for the purposes of the lifetime allowance – but that’s the least of my friend’s worries!


The value of using the risk free pension rate.

I’m getting used to getting my friends at Retirement Line to give me quotes. They are happy doing this work – I tell them they’ll get a thank you on this blog – and this is it!

If we don’t know what certainty we can purchase with our money, how can we measure the risk and reward of moving away from that benchmark?

I think that an absolute pre-requisite in terms of financial decision making but I wonder how many people have entered into drawdown arrangements without ever having looked at the annuity alternative?

I also wonder how many people have taken their tax-free cash and are sitting on the remainder of their pension pot wondering what do do next. These are the people who should be phoning up Retirement Line – not just me!

And of course , this risk free pension rating service can be used for more than quotes. Retirement Line tell me well over half the annuities they set up get an enhanced rate from one of the1500 factors that make us less than perfect – in terms of our life-expectancy.

Screenshot 2019-08-31 at 08.18.13

About henry tapper

Founder of the Pension PlayPen, Director of First Actuarial, partner of Stella, father of Olly . I am the Pension Plowman
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2 Responses to What price certainty? (Boring blog on annuities and drawdown)

  1. John Mather says:

    FV – £186,000
    Term Income GMA
    8 years (to age 65) £24,171.36 £0

    IRR 0.8718%

    Mortality risk?

  2. Eugen N says:

    Henry, you are acting a bit as a (retired) financial advisor 😂😅Nothing wrong with that, but I cannot stop myself mentioning! 😉

    As she wants to bridge for 5 years until age 62, a ‘risk free’ drawdown from the money purchase pot would be a good option (this replicates the fixed term pension annuity investments). She will make phased drawdown (25% tax free, 75% taxable every month). Probably I will recommend a 10% cash (earning 0.5%), 10% in SevernTrent 1.3 RPI redemption 2022, 40% in 1 7/8% index linked Treasury redemption 2022, and 40% in 1/8% index-linked Treasury redemption 2024 – to match as close as possible the cashflow needed. I would not have charged more than £1,500 either.

    Re 5% per annum reduction for early retirement from the DB – is she not ‘overconfident’ that she will outlive the actuarial life expectancy assumption for the scheme members by a few years? She is probably in a white collar pension scheme, who are financially astute (unhealthy people have already transferred our!) – I can sense some overconfidence behavioural bias here!

    There is another thing she may not be aware. Assuming she will not purchase a pension annuity with the money purchase pension fund, then she loses the long term investment return. However I sense from your text that she is not a risk taker, so probably not loss here.

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