If you can afford to wait annuities may give better returns

AT CURRENT rates anyone who can afford to take a modicum of risk with their pension pot at retirement will probably want to delay buying an annuity until they are older.

Rates tend to offer better value at older ages simply because the cost of buying a guaranteed income level reduces according to how much time you have to live.

Buying an annuity can be put off by taking income withdrawals instead – otherwise known as an 'unsecured' pension or income drawdown. This involves a range of risks, as well as higher costs, and there is no guarantee that it will provide an increased income over the longer term.

But drawdown has other advantages. It is flexible and the level of pension income can be varied from year to year within certain limits. It is possible to draw down the tax-free cash entitlement in instalments without taking pension income until later. This is particularly useful to avoid tax while working part time. Death benefits are also more favourable than under an annuity.

Obtaining reasonable value for money against an annuity necessitates investing the retirement fund in a manner that involves investment risk. This is because 'safe' investments will be most unlikely to generate enough of a return to match the yield on an annuity. For retirees who cannot afford to take big risks this creates a difficult choice between the annuity 'devil' and 'deep blue seas' of pension drawdown.

Seeking to bridge this gap is a range of new 'third way' retirement pensions, which aim to provide the flexibility and other attractions of income drawdown but without the risks. They offer drawdown with some insurances.

In the US, where these are known as variable annuities, they have grown exponentially over the past 20 years. But deciding whether to adopt this new type of drawdown plan is no easy task, because of the extra cost involved over and above those of normal drawdown arrangements. Typically, this will be in the region of 0.75% to 1% per annum.

That doesn't sound a lot for some serious peace of mind, but the cumulative effects over 10 or 15 years can be significant.

The two big questions are: is it worth it and do you need it? The impact of the extra cost on a typical drawdown plan could be as much as 20% over 15 years, and that means 20% less to secure the ultimate pension through an annuity.

Proponents of the 'third way' argue that the inclusion of certain income guarantees will permit a higher level of equity exposure in the underlying portfolio than would otherwise be the case and that the expected extra return should go some way to offsetting the extra costs of income guarantees.

The counter-argument is that a well managed drawdown portfolio should employ risk management techniques that will allow adequate equity exposure anyway without significantly increasing the relative risk to the investor.

But what is a well-managed drawdown portfolio? The answer is relatively simple: one that consistently pays out more profit than an annuity.

But achieving that with any real confidence is not so simple. The key is in the 'asset allocation' strategy which must be designed to weather even the most severe investment storms, while gaining ground from periods of growth.

This is achievable by having a suitably diversified range of funds weighted according to the needs of the individual. Discounted cash flow models incorporating other present or future income streams such as state pensions and investment income provide a drawdown income profile that 'informs' the asset allocation strategy.

In current investment conditions, for instance, any drawdown plan established in the last few years that had included in an index linked gilt fund for short term protection will currently be paying out benefits at a very handsome profit for the investor.

Furthermore, capitalising healthy gains on sovereign bond funds over the past year means extra equity units can now be bought on the cheap to enhance future payouts once stock markets recover.

Making unsecured pensions 'safer' evidently requires either a smart investment strategy or 'third way' insurance at an extra premium, but certainly not both.

• Steve Patterson is managing director of Intelligent Pensions