By James Baxter, September 2019
It’s common knowledge that annuity rates are presently low, making annuities an expensive way to convert your pensions savings into lifetime income at retirement. But just how low are they?
The chart below shows the target investment returns you would need to make to match current ‘best buy’ annuity rates at age 60. In each case they are joint life annuities with a 50% spouses’ pension.
Drawdown target returns to match current annuities, targets at age 90 shown. Source: Tideway in-house analysis
The chart shows that to get your money back you now need to live to at least 86 on a level annuity and 89 on a 3% per year escalating annuity.
Both annuities only need a target return of 2.4% net fees to match the annuity payments to 100.
So, how achievable are these kind of returns in a pension drawdown account, taking account of fees?
On the face of it 0.5-1.1% p.a. seems like a very low target, but it comes at a time where the risk-free return is shockingly low. At the time of writing, and according to the FT website a 20 year UK gilt now pays a yield of just 1.08% p.a. to maturity. After any kind of costs for running a pension drawdown account investing in gilts is going to produce a sub 1% p.a. long term return.
Similarly, low risk corporate bonds now have very low yields. According BlackRock’s iShares website the weighted average yield to maturity on their Core GBP Corporate bond ETF (SLXX) stood at 2.2% as of the 13th September. Unless interest rates fall further from here the returns from vanilla corporate bond funds, allowing for the costs of running a drawdown account, are going to be sub 2% a year.
These funds and longer dated gilts also carry real short-term risk to capital if interest rates rise. As can be seen in the chart below, SLXX fell almost 2% in one week this month as longer-term interest rates started to recover. Given the low yields on this fund, unless rates fall back again, its going to take someone buying at the beginning of September at least a year to get a positive total return from this popular investment.
According to BlackRock iShares there was £1.9bn invested in the SLXX ETF as of 13th September 2019.
Higher Yield, Hybrid Capital Fixed Income
The attraction of fixed income securities is getting a known return for a set period and you can typically get better fixed income returns lending to large big brand companies in what’s called hybrid capital fixed income securities. These have terms and conditions which generally make them a bit riskier resulting in higher interest payments. Sticking with big brand issuers the risk of defaulting on the planned payments can be kept pretty low.
According to Bloomberg on the 16th September 2019 the following issuers all had hybrid bonds in issue yielding more than 4.5% a year to maturity. Even allowing for fees this will translate to a 3-3.5% p.a. return in a drawdown account.
Funds investing in hybrid bonds are offered by Royal London, Tideway and other specialist fixed income fund managers.
Multi Asset Cautious Managed Funds
The IA Cautious Managed 0-35 sector tracks mixed asset managed funds with less than 35% exposure to equity markets. The chart below shows the average annual return from these funds over the last 30 years.
IA Cautious Managed 0-35% Equity Average Annual Returns - FE Trustnet September 2019. Source: FE Analytics/Trustnet
Whilst returns from this type of investment strategy have fallen in the last 5 years, its worth noting that for the last 5 years we have had low gilt yields having fallen from around 10% p.a. in 1990 to sub 2% p.a. in 2012. Well diversified multi asset funds should hold other investments where returns should be in excess of inflation over the long term including for example real estate and infrastructure as well as shares and bonds.
Again, allowing for fees these types of funds should give a lower risk return or around 3% p.a. or more.
Using a SIPP To Lower Risks Further
A key attraction of using a SIPP drawdown account rather than an insured pension plan is the ability to hold a mix of different assets segregated within the account as oppose to mixed together in a single unitised fund.
With a SIPP portfolio like this its possible to take the natural income yield of the portfolio and hold low risk funds like short dated bond funds to supplement this income whilst holding more volatile investments for the long term. This avoids one of the biggest risks to drawdown which is finding that you have started your account just before a big market correction that then means you start selling investments at a loss.
Setting aside the extra value of flexible access and control of capital that comes with drawdown versus an annuity, given most people won’t live to age 90 then for most the downside risk is achieving a nominal return after fees of less than 1% a year.
On the upside, taking a conservative view on returns from cautious managed funds or hybrid capital fixed income, achieving 3% a year return after all fees should be manageable without excessive risk. The chart below shows the surplus funds this would produce as compared to current annuity rates in the form of the residual account balance over time, which could either be passed on or used to fund higher withdrawals.
Drawdown account value over time with matched withdrawals to annuities and assuming 3% returns net fees, account values shown at age 90. Source: Tideway in-house analysis
James Baxter partner at Tideway Investment Partners LLP has been a financial adviser since 1986, founding two successful wealth management companies both trading successfully today.
An early mover to fees in the 90's more than a decade before RDR banned commissions, James has been a proactive and forward-thinking adviser on investments and pensions. He has made a number of appearances on BBC Radio 4’s Money Box programme as well as contributing to articles in the FT, Telegraph, Times and Investor’s Chronicle.
Most recently since the advent of pensions freedoms and as a qualified and experienced pension transfer specialist, James has been at the forefront of the debate on defined benefit pension transfers. He is passionate about tax planning and investment strategies for generating tax efficient sustainable income in retirement.
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