Hopefully, you will know what an annuity is? It is a policy which converts a capital lump sum (e.g. your pension pot) into guaranteed regular (monthly) income payments.
If you would like to know more about annuities, please go the annuity page on my website
Annuities have been in existence for a long time. The first recorded annuities were in Roman times and in 1811 Jane Austen wrote: “An annuity is a very serious business” in Sense and Sensibility.
Today the most popular annuities in the UK are pension annuities and these have the following characteristics:
But you probably don’t appreciate the advantages and benefits of annuities because of the negative publicity and dare I say it, “fake news”. We have always prided ourselves on presenting both sides of every argument in a balanced and fair way. So, in this article we will present the pros and cons of annuities in a balanced way.
The case for annuities can be made very simply; they are the only policy that pays a high level of guaranteed income for the rest of your life. In this sense an annuity is a pension, and in the rush to introduce pension freedoms it is easy to lose sight of why you probably saved for a pension in the first place.
Annuity rates may be low at the moment but they are the only way of guaranteeing a regular income for the rest of your life with peace of mind and security no matter how long you live.
Economists have been interested in the concept of annuitisation (the process of converting a lump sum into income for life) for a long time and have argued that those who want to find the best way to stretch their income over their lifetime should purchase an annuity.
If you don’t arrange an annuity and take income directly from your pension pot (e.g. pension drawdown) you are faced with two dilemmas:
Annuities solve these problems by guaranteeing income for as long as you (or your partner) are still alive and by providing an internal rate of return higher than cash but without any investment risk.
‘In the long run we are all dead’ said the economist John Maynard Keynes, but how long is the ‘long run’? It is often much longer than people think because many people grossly underestimate their life expectancy.
This may have serious consequences for your retirement planning because it increases the risk of running out of income in later life.
You can find out your average life expectancy with the life expectancy calculator on my website
One of the reasons some people do not like annuities is that they worry that if they die soon after taking out an annuity, the capital is gone and there is nothing to pass on to the rest of the family. But the flip side is that if you live well beyond your normal life expectancy, you will not outlive your income if you have an annuity.
In order to meet the income for life promise, annuities are based on the concept of mortality cross subsidy.
Annuity rates are calculated assuming you will live until your normal life expectancy. But some people will die before they are expected to and some will live longer than expected. Insurance companies make a profit from those dying early and a loss from those living longer, but they use savings from the early deaths to subsidise the income paid to those who live longer than expected.
This is called mortality cross subsidy. It is unique to annuities and clearly favours those in good health who may live longer than expected at the expense of those who die early.
To overcome this problem insurance companies offer enhanced annuities, which pay a higher income for those who have a medical condition that may reduce their normal life expectancy.
Those who smoke, take prescription medication or have been in hospital recently may be able to qualify for an enhanced annuity.
Find out more about enhanced annuities
An important part of retirement income planning is making sure you have sufficient income to maintain your chosen lifestyle for the rest of your life.
The best way to do this is to plan ahead but the idea of preparing a budget can be a daunting prospect. But when you have done this you will be in a much better position to work out how much income you will need and where it will come from.
When planning, don’t forget to take account of inflation as this reduces your spending power over time and don’t forget your income require¬ments may change over time, for instance you may not spend as much during the middle part of your retirement.
A popular and useful planning technique is to build an income pyramid. Using this approach all essential income should be totally guaranteed, income for desirable expenditure such as holidays should be as safe and secure as possible while non-essential income can be taken from more risky investments.
Annuities are a good way to secure a solid base of guaranteed income to pay for essential income needs. In many cases it makes sense to strengthen the foundations of the pyramid by purchasing more annuities in subsequent years.
Not only does this increase the amount of guaranteed income, it takes advantage of the increased benefit from mortality cross subsidy as you get older.
Although we recognise the advantages of annuities (after all we have been advising on them for over 25 years) many people don’t like annuities, often describing them in colourful language such as ‘legalised theft’ or “a rip off”.
Annuities are not right for everyone and they do have some limitations and disadvantages but before dismissing them outright it is important to correct any misconceptions or misunderstandings.
Nobody has described the possible flaws in annuities as eloquently as Lord Grantley, who speaking in a House of Lords debate on pensions in October 1997 said: “In my view, there are two overwhelming reasons why people should not invest in annuities under any circumstances. The first is that investing in annuities is contrary to the interests of a family … in that they are worth nothing when the investor dies. The second reason is simply that annuities are a lousy form of investment.”
Lord Grantley is wrong on the first point because people purchasing annuities can have a guaranteed period or capital protection and if they are married they will have a joint life annuity which will continue as long as their spouse or partner is still alive. In this sense they can be good for the family.
There is nothing wrong with the concept of annuities – it is just that interest rates have been at historically low levels since the credit crunch in 2008
I do have sympathy for the assertion that annuities are a lousy form of investment, however, as annuities are not an investment but a type of insurance policy.
There has been a lot of academic research into the value for money of annuities and these have all concluded that annuities are fairly priced and annuitants are getting a good deal with an annuity.
This may be difficult for many people to appreciate when the payouts from annuities are so low, but there is nothing wrong with the concept of annuities, it is just that interest rates have been at historically low levels since the credit crunch in 2008.
Low interest rates are good news if you have a mortgage but bad news if you are relying on the interest from your savings.
However, despite low interest rates there is still a strong case for annuities because through the hidden power of mortality cross subsidy they are still the only policy that can guarantee an income for life.
There is one limitation to annuities and that is lack of flexibility. Once an annuity is set up the terms cannot be changed no matter what happens to your personal circumstances or interest rates.
This is especially relevant since the advent of Pension Freedoms in 2015 because now everyone has the freedom and flexibility to spend their pension pot as they wish and when they die, any money left over can be left to the family.
In my experience, many older people end up with complicated solutions they probably don’t understand and are taking more risk than is good for them
However, freedom is not license and it can be very risky. Just because you have flexibility it does not mean you should spend your pension pot unwisely and take undue risks.
The most powerful argument in favour of annuities compared to other options was in a paper entitled ‘Annuitisation; it shouldn’t be a secret’ published by the National Association of Variable Annuities (NAVA) in the US over 20 years ago.
It contained some important observations about the concerns and needs of retirees including:
I particularly agree with the point about simplicity and structure especially because, in my experience, many older people end up with complicated solutions they probably don’t understand and are taking more risk than is good for them.
The paper went on to give reasons why people don’t take annuities more seriously:
This last point; the mistaken belief that drawdown is always better than an annuity, is often overlooked.
I will look at this in the next newsletter which will focus on drawdown in more detail.
There is a strong case for annuities in the right circumstances.