Annuities - life after pension freedoms
Annuities - life after pension freedoms
There are few people who like or understand annuities as much as I do, but that doesn’t stop me casting a critical eye over the annuity market.
I hope I have been consistent with my support and criticisms of annuities over the last 25 years and I can sum up my view in one sentence: “There is a strong case for securing a guaranteed income for life but it is important to consider the alternatives before making an irrevocable decision, especially at a time of such low interest rates”.
The fate of annuities was sealed in 2014 when George Osborne announced “no one will have to buy an annuity” and pension freedoms were introduced. In reality, the fate for annuities was sealed about 5 years earlier when large brokers and insurance companies started to sell annuities purely on price and annuities became a commodity. My criticism at the time was most people were shopping around for the best price without asking themselves if they were shopping for the right thing in the first place.
There is little point in looking backwards and hankering back to the days when it was possible to have a properly informed discussion about the advantages and disadvantages of annuities but there is every point in looking forward to the role of annuities in the retirement plans of those retiring now and in the future.
In my opinion, a proper analysis of the role of annuities in the future should consider the following matters:
Are annuities fit for purpose?
The short answer is yes. Let’s not forget that annuities are the only policy that can guarantee an income for life, no matter how long that is. The alternatives may be more flexible but they do not guarantee the income will never run out.
However, this peace of mind and security comes at a price so it is important to consider ‘value for money’.
I think the best way to think about value for money is to think of an annuity like a mortgage in reverse; “People pay their money over to the annuity company who then pay back the original capital plus interest until the annuitant (and if a joint life, the partner) dies”. If they live longer than expected they will get more than their original capital back but they die sooner they may not have got all their money back.
When interest rates were high this was a good deal but with low interest rates and bond yields, annuitants living to their normal life expectancy will only have received an implied interest rate of about 2%.
Therefore the question clients and their advisers should ask themselves is “does it make sense to lock annuity income, which could continue for 20 or more years, at today’s current low interest rates? ”
See the latest annuity trends
Why should anybody purchase an annuity now we have pension freedoms?
Anybody, rich or poor, who is serious about securing a guaranteed income for life should consider an annuity. Put simply there is no other way of guaranteeing an income for life
However, annuities do not have to be purchased in one go and some of the best advice solutions I have recommended in the past have involved an element of phasing i.e. purchasing annuities in stages.
There are many advantages to a phased annuity strategy including benefiting from any increases in the underlying interest rates, benefiting from mortality cross subsidy and de-risking a drawdown plan.
What is best an annuity or drawdown?
This is probably the most difficult question in retirement planning so I cannot give any easy answers here, but I can make a few general comments:
- The grass make look greener on the drawdown side of the fence but it can all be eaten up very quickly
- Many people underestimate their true attitude to risk and capacity for loss which means they will be in for a shock if there is a downturn in global equity markets
- Many people base their decision to invest in drawdown rather an annuity on the basis they want flexibility and the option to leave money to their family after their death. These are understandably important objectives but the need to secure their own income may at some point become more important than having flexibility and control. The problem is knowing when this change in priorities happens.
What about enhanced annuities?
Most people know it is possible to get a higher annuity income if they smoke, are taking prescription medication or are having medical treatment but not everybody gets the best rates because there is a skill in applying for enhanced annuity rates.
Valuable as they are, it is worth pointing out there is no free money here (unless the annuity provider is too generous with its assumptions) because an enhanced annuity just accelerates the repayment of the original capital to reflect the reduced life expectancy.
Why advice is better than no advice?
I can understand why some people think they don’t need advice and can make the decisions about their retirement income on their own (or using a no-advice broker) but they may be fooling themselves. It is difficult to get it right and the cost of getting it wrong may be very high.
The financial services industry has not made it easy for people to get advice and there is a myth that financial advice is expensive and complex. I have been advising clients for over 25 years and I feel more strongly than ever that everybody should get advice when making one of the most important decisions of their life. This may fall on deaf ears but don’t forget:
- Without advice people may sleep walk into the wrong solution with disastrous consequences
- It may be tempting for people to follow their own instincts but this may lead them down the garden path because the best decision may be counter intuitive
- I can give people jolly good advice for less than the commission paid to non-advice brokers
One the one hand there is a strong case for annuities because they are the only policy that can guarantee income for life with total peace of mind and security.
On the other hand annuities are inflexible and the income is mainly repayment of the original capital because with current interest rates there is very little added interest.
Since the start of pension freedoms in 2015, annuity sales have been in a downward spiral while drawdown has been in the ascendency. However, this could all change if bond yields rise and the equity markets fall in value.
Watch out for future blogs which will monitor the relative merits of annuities and drawdown as the UK navigates through the Brexit process.