Why would anyone want an annuity?
A month after the announcement of the new pension freedoms last March, research published by Your Money indicated only 25 per cent of retirees intended on buying an annuity – and many annuity holders began asking whether they could cancel their annuities, and get their money back. In the year that followed, annuities providers across the board reported sharp falls in annuity sales, falling purchases rates in turn led to annuity incomes falling even further, there were calls for an outright ban on automatic annuity purchases, and sales overall that year almost halved. Now, new rules could mean annuity holders will be able to sell their contracts if they wish.
It would appear, then, that annuities have been dealt a fatal blow. Or have they? “Despite the pension reforms, annuities may still turn out to be the best option for some,” believes Jane Vass, head of public policy at Age UK. “For many, an annuity is still the right retirement option” agrees Andrew Pennie of Intelligent Pensions.
The obvious question, then, is why? “The most important aim in retirement is to ensure that you have a guaranteed income that is as reliable as is possible, to ensure you’re always able to pay for the essentials,” says Adrian Lowcock of AXA Wealth, “and an annuity is one of the most dependable products for achieving this end.” Pennie agrees, noting that “annuities remain the only way to secure an income for life.”
The alternative to buying an annuity is to withdraw your money via drawdown, holding it as cash or building up an investment portfolio, and using any dividends or interest generated as income.
However, there are a number of potential issues with either approach. For a start, only 25 per cent of your pension can be withdrawn tax free – the rest will be taxed as income. This presents the obvious risk that a retiree could wipe out a significant chunk of their pension pot in tax liabilities. It is difficult enough to amass a pension pot large enough to fund an entire retirement is in the first place and retirees outliving their savings is already a major problem – “at present, people underestimate their lifespan by about ten years,” says Lowcock. Losing a sizeable chunk to tax raises the prospect of a pension being eroded even more quickly.
Equally, inflation may erode the value of pension funds over time. Inflation for 65 to 74 year olds between 2007 and 2014 was 27.3 per cent, an average of 3.5 per cent per year. Annual inflation of 3 per cent can halve money’s spending power in just 23 years. “Even mild inflation over 20 or 30 years can have a significant impact on your wealth,” Lowcock notes, “so protecting against inflation will be essential for maintaining your standard of living.”
Furthermore, someone who is heavily reliant on their pension (i.e. a pensioner with few – or no – other sources of alternative income) cannot depend on an investment strategy for income – with limited resources available to them, taking on the risk that their investment may fluctuate in value may not be appropriate.
One way or another, choosing to withdraw your pension multiplies the odds that you could use up all your money before you die. With an annuity, these risks are much less pronounced, as they guarantee a fixed income, and can be insulated against inflation. What’s more, Pennie thinks it important to bear in mind that the new freedoms don’t oblige pensioners to choose an annuity or drawdown – and that the real question is not whether to annuitise, but when. “As retirees get older, annuity rates improve and it becomes increasingly difficult for drawdown returns to consistently keep pace. Drawdown exit strategies need to be tailored to an individual’s unique circumstances but we typically identify ages 75-80 as being the ‘decade of annuitisation’.”
“Furthermore, I don’t believe there is any single correct day to buy an annuity – the best drawdown exit strategy is a phased one.”
A spokesperson for LV= states the firm believe annuities “will continue to play an important role in retirement plans.”
“The certainty annuities offer mean a retiree won’t outlive their pension fund. Increasingly, it’s becoming apparent that an optimal approach – and an approach favoured by a growing number of retirees – is one that combines products. For example, mixing income drawdown with an annuity, in order to achieve a greater level of income flexibility whilst retaining a guaranteed income element. We expect this to demand to continue to rise over time.”
“Deciding how to fund retirement is one of the biggest financial decisions someone will have to make and we believe that financial advice can help ensure that savers make the most of their pension pot.”
Intelligent Pensions have published an ‘Annuity or Not’ Calculator on their website, designed to give retirees an indication of whether buying an annuity is the right option for them. By completing a simple online questionnaire, a respondent will be given an outcome with supporting information and recommended next steps. It’s even possible to go back and input different scenarios, to see how your result would change in different circumstances. Click the image below to try it out.