“Let me be clear: no one will ever have to buy an annuity again” (George Osborne, Budget speech, 19th March 2014†).
This was a watershed moment for retirement income planning, as people can now draw down as much as they want from their pension pot from the age of 55. However it is worth noting that no-one has had to buy an annuity since 2006.
Mr Osborne was perhaps of the opinion that no one really wanted to buy an annuity, and that they should be released from the constraints that they impose. What’s the truth about annuities ? Are they a product which offers no flexibility or are they in fact inevitably secure?
Flexibility versus certainty
If you invest in a drawdown plan, every time you make a withdrawal you are spending your capital. The more you spend, the more likely you are to run out of money before you die. Once you’ve spent the capital you can no longer draw an income from it.
Admittedly you could take a ‘natural income’ as your strategy, drawing only the income produced from your investments, but this will fluctuate. It will result in you being able to pass on capital on your death, but at what cost to the income you could have taken through an annuity?
So what’s more important? The chance to retain some flexibility through drawdown, or the opportunity to seek to maximise the source of a guaranteed income? This is the question that needs to be asked. What really matters most, flexibility or certainty when it comes to retirement income?
Seeking out best in market rates – it really does make a big difference!
I have some sympathy with those that believe annuities offer poor value. Poor value annuities continue to provide certainty, but at a significant cost. For example a male purchasing an income with £50,000 on a single life basis and guaranteed for 5 years, where the gap between the worst and best standard rates is 16%. When you take into account their health and lifestyle, for someone with
moderate health conditions, this increases to nearly 26%. That’s over a quarter more income!1
Perhaps seeking out the open market option and best underwritten rate should be made mandatory for those seeking a guaranteed lifetime income? Would this not change the perception of the value that an annuity can provide?
Meeting the needs of longevity
Longevity isn’t about how long people live on average, it’s about how long they might live. Let’s take 65 year olds – if they’re in average health (which means not being in perfect health for their age, but they’re also not suffering from any serious ongoing illness. They might, for example be a little overweight and/or their blood pressure may be higher than their doctor would like it to be, or perhaps they might be suffering from high cholesterol and taking medication) they’ll live until age 90 if they’re male and 93 if they’re female. That’s between 25 and 28 years.
But 50% of people will live longer than this! For males there’s a 25% chance of living to age 96 and for females this rises to 98.2. What does this mean? Well, if they‘re male and live to age 90, based on the best in market standard annuity rate of 5.5%3, this equates to a return of 137.5% of their original investment. If they’re one of the 25% who live to age 98 this increases to 181.5%. So they get their money back and an additional return of 81.5%.
Admittedly they might be one of the 25% who only live to age 83 if they’re male and age 86 if they’re female, but who’s prepared to take this chance? An annuity provides an insurance against your longevity. The longer you live, the better the value you get. It’s an insurance that guarantees you receive an income for the rest of your life. How do you put a value on that? After all, no one knows with any certainty how long they are going to live. Choosing not to insure your income would appear to be gambling with how long your funds need to last.
How many people living into their 80’s and beyond want the complexity and risk associated with investment markets? Isn’t it time we anticipated this change in attitude and started to plan for it now with the purchase of a guaranteed income for life?
Lower annuity rates and improved life expectancy
We’ve grown accustomed to a low interest rate economy with the Bank of England base rate at 0.5% since 2009 which has had a resultant impact on fixed interest yields, so it’s no surprise that annuity rates have fallen. But it isn’t just fixed interest yields that affect annuity rates – it’s also a result of improvements in life expectancy. Since 1991 there has been over a 30% improvement in life expectancy for ales age 65.4. This rate of increase is unprecedented and who’s to say that it won’t go on increasing?
Against this background an annuity is providing a lower rate of income than 20-30 years ago, but for a significantly longer time period. The true value of the annuity can only be gauged at the point of death, but based upon the longevity stats shown above its looking like a fairly attractive option.
Death benefits – the annuity doesn’t need to die with you
Gone are the days when the benefits of an annuity died with the recipient. It’s now possible to guarantee the income will be paid for many years – in Just Retirement’s case, this is for 30 years. So if our male of 65 dies as expected at age 90, income payments could continue for a further 5 years. This guarantees the individual will get value from their annuity – if you measure value as getting
a positive return on the capital invested.
You can also protect the value of your purchase price by opting for the Value Protection feature – which results in a tax-free payment if the annuitant dies before age 75 and is taxed at the beneficiary’s marginal rate thereafter.
The value of pooling
We’re able to deliver better value because of the size of the pool of people that purchase an annuity. We can make guaranteed lifetime income payments assuming people die on the date expected. You couldn’t do this as an individual and that’s why no individual can ever replicate the value of certainty delivered by a lifetime annuity. Whatever they assume they will be wrong and either end up with too much money, or run out of money early, before death.
The benefit of pooling resources with others is that you will never run out of money. Some will be real winners, but no one will be a loser as they will still get the value of certainty of income for life – a priceless commodity.
For each year you remain in income drawdown you run a higher risk of running out of money in your pension fund as the investment return you need, to maintain the same level of income, will need to increase. This is called ‘mortality drag’. As you get older, the effect of this mortality drag increases.
With an annuity you achieve mortality cross subsidy – the opposite of mortality drag. Let’s not ignore this hidden benefit of annuities – its worth around 1% p.a. of your total return at age 70, rising to over 3%5 p.a. if you defer annuitisation to age 80. This means that if you go it alone (e.g. through drawdown), you’d need to be able to guarantee an additional rate of return of this amount over and above the return required to support your income at the outset – the longer you leave it the greater the mortality drag you experience.
How hard is it to generate an extra 1% guaranteed, risk free return for life for a 70 year old and how much harder still does it become when this increases to over 3% by age 80?
No one will ever have to buy an annuity again – but many will choose this option
Let’s return to the Chancellor’s comments. For those that require some additional secure income to meet their essential expenditure, who are risk averse and do not want the uncertainty of stock market investment, an annuity offers considerable attractions.
But should we not ensure that every individual who purchases an annuity seeks out the best available rate on the open market – a rate that may be 26% (over a quarter) higher for someone with moderate health condition when purchasing an underwritten annuity?
Source: Just Retirement
† George Osborne’s Budget 2014 speech
1 Example from 21.04.2016 based on single life basis; age 65; annuity purchase price 50k; RH2 7RT postcode; no escalation; 5 year guarantee period,
average adviser charge 2%. Moderate health conditions apply: Diabetes Type 2 diagnosed 5 years ago, supplied HbA1c readings and takes 1 med daily, 25
units of alcohol weekly.
2 Just Retirement longevity calculator page: www.justadviser.com/financial-planning/calculators/longevity/
3 £50K purchase price, RH2 7RT post code, no escalation, 5 year guarantee period, paid monthly in advance – rate as of 13/01/2016
4 Life expectancy National Statistics website release 4 November 2015