Why buying an annuity when you retire might still be the best option
Annuities have endured a tough time since 2009, as non-existent interest rates and record-low gilt yields pushed down annuity returns.
Things went from bad to worse in the March 2014 Budget when Chancellor George Osborne announced radical reforms to the UK pensions regime, in effect removing the need for people to buy an annuity at retirement. Since then, rates of purchase have collapsed and annuity incomes have tumbled further.
“The flexibility offered via drawdown, and now flexi-access, coupled with the ability to pass on value to your wider family, has rendered annuities a product many clients do not feel suit their circumstances,” explains Alex Brown, senior consultant at wealth manager Mattioli Woods.
However, annuities are still attractive to some retirees and remain a viable option in some instances.
Brown believes there will always be a market for annuities among individuals who appreciate a guaranteed income and who want certainty in their retirement.
“Those who have no children, for whom the ability to pass on wealth is not a primary concern, may be also wise to at least look at annuity rates,” he says.
Dennis Hall, CEO of Yellowtail Financial Planning, believes annuities could be a good fit for nearly every retiree.
“The only circumstance in which I think an annuity wouldn’t be worth considering is if you’re in absolutely brilliant health, with such sizeable assets that significant losses will not impact your quality of life in retirement, or the legacy you leave behind,” he says.
Brown is less positive about their relevance – at least for the foreseeable future.
“Rates are at a historic low. Until they improve and offer what investors see as a genuinely attractive return, the savvy will look at alternatives,” he says.
The reasons a retiree may favour an annuity vary from individual to individual, depending on their means, needs and financial objectives.
For those who want access to a guaranteed income throughout their retirement, and have essential spending covered until the day they die, an annuity may be one of the more dependable ways of achieving this end. Annuities also protect against other uncertainties.
“No one knows for sure how long they’ll live – people have a tendency to underestimate, rather than overestimate,” says Steve Patterson, managing director of Intelligent Pensions.
“An annuity is an insurance policy against this, allowing retirees to preserve capital, while living off a predictable income.”
People tend to underestimate their lifespan by roughly ten years on average – although even an underestimation of one or two years could have significant implications for a retiree, and mean they spend their final years destitute.
The common alternative to buying an annuity is to enter drawdown (holding a pension as cash, or investing it, and using it – plus any dividends or interest generated – as income).
But drawdown has its disadvantages. Only 25 per cent of a pension can be withdrawn tax-free, with the rest taxed as income. A retiree could significantly deplete their pension due to tax liabilities, and the prospect of taxes further eroding a pension which may not cover an entire retirement in the first place will be troubling for many.
“Drawdown can seem an attractive option, and will appear especially attractive in the early years of retirement – but many people who intend to enter drawdown don’t have enough money to sustain them through retirement to start with,” says Patterson.
Furthermore, using drawdown to invest in higher-risk assets such as equities poses the obvious risk that a crash could wipe out an entire retirement fund – and the older you are, the lower your earning power, and the less time you have to absorb and recover any losses.
“The convention of reducing your exposure to risk and move into safe, fixed-income products when you reach retirement is rightly being challenged – retirements are stretching out longer and returns from equities and real assets are much better than those offered by ‘safe’ vehicles,” says Hall.
“But, markets are volatile, and conditions can change rapidly – also, you have no idea what inflation will do. At the least, an annuity could be a way of hedging bets.”
This leaves the question of when to buy. Even advocates of annuities agree you do not have to purchase one immediately at retirement.
“Don’t take an annuity early – or, if you do, take out a small annuity, and use that as a regular source of income to cover core expenses, while you try to grow your finances in other ways,” says Hall.
Patterson says when an annuity should be purchased is subjective.
“There is no single day – no universal annuity purchase point.”
However, he suggests a ‘decade of annuitisation’, running from 70 to 80. This adjusted timeframe allows retirees to enjoy their lump sum, and perhaps enter drawdown for an allotted period, before a structured segue into fixed-income.
Another benefit of waiting is that annuity rates will improve as and when interest rates and gilt yields rise. While increases in both are likely to be sporadic and small, market conditions will only grow more favourable over time.
Brown believes external factors could potentially lead to a resurgence of the traditional annuity purchase model in future.
“Investment market volatility and the effect on drawdown income levels and residual fund values, could see a sway back to annuities,” he says.
“Likewise abuse of flexi access, evidence of hardship in retirement for those who ‘blew’ their pension might also support the annuity concept – but I doubt it. They remain stigmatised as poor value, with holders needing to live 20 years just to get their capital back.”