Worrying Parallels Between Pension Income Drawdown & Endowment Mortgages

Written by Karen Bryan

£1 coin pile7Whilst endowment mortgages were all the rage in the 1980s and 1990s, I always avoided them. Call me too risk averse, but I preferred the certainty of a repayment mortgage, giving us the assurance that our mortgage would be paid off by a certain date.

Of course, people buying a property liked the idea of endowment mortgages because they were hoping/told that the payout for the endowment would be larger than their outstanding mortgage, so they’d be left with a nice cash bonus. Those selling endowment mortgages liked the commission from selling these products.

In fact, many people had shortfalls on their endowments, meaning that the endowment maturity value wasn’t enough to pay off their mortgage. To me, this was an obvious risk if the underlying endowment investment was in stocks and shares.

Now I’m starting to feel the same unease, that I experienced with endowment mortgages, about income drawdown being the latest ‘in’ option for your pension pot. Income drawdown is where you take an income from your pension pot, but leave the pot invested for increased flexibility and in the hope of further growth. Until recently, most people with a personal pension bought a single annuity;  a guaranteed income for the rest of their life. There are two types of income drawdown.  If you have a guaranteed annual pension income of at least £20,000, e.g. from a final salary scheme, then you can enjoy flexible drawdown, with no limits on the amount you withdraw from your pension pot.

However, people with a lower pension income have a cap applied to their annual income drawdown, which currently equates to 120% of what a single life level payment annuity for someone your age would yield per year.

To add uncertainty to future income from income drawdown, this cap can be changed by Government. The cap was 120% until the Government reduced it to 100% in April 2001, then was revised back up to 120% in 2013.

I recognise that there are advantages to income drawdown. If you die soon after starting to take a pension income through income drawdown, your family can get the benefit of your remaining pension pot. (However, your dependents can usually get half the pension income from your annuity if you agree to take a lower pension income by buying a joint life versus a single life annuity.) In addition, if the stock market does well, your pension pot could see a healthy increase.

One of the issues is that it’s considered wise to have your pension pot in a mix of low risk investments and cash as you approach retirement. However, if my husband’s Legal and General Cash Fund is anything to go by, you’ll be lucky if the annual return covers the annual management charge. This means that your pension pot isn’t keeping pace with inflation, never mind seeing any real return.

So what if your pension pot doesn’t deliver the projected annual returns, inflation is high and you live for longer than average? There will be a possibility of being left with a lot less income than you planned during your later years.

Some people may decide to go for income drawdown in the hope that annuity rates will increase. But if annuity rates don’t go up, plus if their pension pot doesn’t increase by more than the rate of inflation, it might’ve been better to buy an annuity earlier.

I may be cynical, but I think that pension providers would be very happy if more people left their pension pots invested, instead of buying an annuity; then pension providers would derive income from annual management charges for a good few more years. Financial advisors could also get more work out of income drawdown, if clients needed advice about which funds to invest their pension pot for longer, than if their clients bought an annuity earlier.

Income drawdown sounds like a very similar scenario to endowment mortgages; a lethal cocktail of the finance industry’s desire to increase revenue from product fees/charges and consumer desire to increase their investment return based on projected (versus guaranteed) pension pot growth. Will income drawdown end in tears for many consumers and possibly another mis-selling scandal?

One Response to “Worrying Parallels Between Pension Income Drawdown & Endowment Mortgages”

  1. Interesting article as always Karen.

    A few points though:

    1. The actual maximum income for a 65 year old with a £50,000 fund is £3,540 per year, not £1,200

    2. It’s a myth that Income Drawdown has to be invested in the stockmarket, it doesn’t! Most people who use Income Drawdown will opt for a diversified portfolio, selecting funds investing in a range of assets including of course equities, but also gilts, corporate bonds, property and cash

    3. “One of the issues is that it’s considered wise to have your pension pot in a mix of low risk investments and cash as you approach retirement.” This only really applies if you plan to buy an Annuity. If you are going to use Income Drawdown it makes little sense to switch to cash in the years leading up to retirement, only to switch back to other assets e.g. gilts, corporate bonds and equities, as enter Income Drawdown

    4. As with all financial products Income Drawdown is right for some and not for others. There are many benefits to it, including wider options on death, the potential for future growth, flexibility to increase and decrease income, deferral of Annuity purchase until a time when rates or better of the retiree qualifies for an Enhanced Annuity. There are of course downsides, investments may perform badly, it requires regular reviews (which people should be doing with their pension anyway) and nothing is guaranteed.

    But then again, the guaranteed income provided by an Annuity carries many problems, not least inflexible death benefits and inflation (very few people can afford to buy an inflation linked Annuity). One also needs to remember that the actual return from an Annuity, based on average life expectancy and retirement age is almost zero i.e. you are only getting your capital back.

    There was a recent debate in London of the pension ‘great and the good’, including experts such as Ros Altmann who debated a motion something along the lines of “An Annuity is riskier than Income Drawdown” (I’m paraphrasing a little) and it was carried; there are indeed times when an Annuity carries greater risk than other alternatives, despite the ‘on the face of it’ guarantees.

    It’s a case of horses for courses, for some an Annuity is right, for others Income Drawdown is a better option. But, there is very little comparison between the way Income Drawdown is advised and Endowments were sold; firstly there is no commission with Income Drawdown, which was one of the main reasons for Endowment miss-selling.

    Come and spend a day in our office Karen and we’ll show you the checks and balances we need to go through before we can advise a client to use Income Drawdown, I think you would be surprised!