One of the cheery side-effects of the country’s borrowing costs rising, is that annuity rates have ticked up again. Every cloud and all that.
Buying an annuity involves selling a lump sum (typically from your pension) to an insurance company, in return for the promise that they will use it to pay you an income for the rest of your life.
The rate of income (annuity rate) offered by these insurance companies will vary based on a number of factors - where bond yields are (which is why annuity rates have been rising recently), the age/health/life expectancy of the purchaser and the terms of the annuity.
On this final point, a (confusingly) wide range of jargon-y options are available when you buy an annuity. These are summarised below, along with a plain English explanation of what they mean.
Indexation - Annuities can either be purchased on a “level” or “indexed” basis. When the latter is chosen, the annual income paid will rise in line with the chosen “escalation rate" (most commonly RPI, a measure of inflation).
Including indexation makes the annuity more expensive, but for a relatively healthy individual at retirement it really is a necessity. You could be retired for 30 or 40 years - over these timeframes, your cost of living is going to increase massively and your income needs to keep pace with these increases.
Guarantees - Buying an annuity with a “guarantee period” ensures that the income will continue to be paid for a minimum period e.g. 5 years regardless of whether you live that long. Including this feature reduces the rate paid.
Spousal Benefit - Annuities can be set up to continue to pay a proportion of, or even the full prior rate to a nominated beneficiary on death. Including this feature again reduces the rate paid.
Payment Frequency - Payments can usually be made monthly, quarterly, half-yearly or annually. When payments are made more frequently, this has a (modestly) negative impact on the rate offered.
Choosing to buy an annuity is a Type-1 financial decision. It is an irreversible, “one and done” action and as such it must not be entered into lightly.
Advantages of an annuity
Annuities offer certainty of outcome. This is the main reason that anyone would want to purchase one.
When we buy an annuity, we effectively remove an element of uncertainty from our lives and transfer this onto the balance sheet of an insurance company.
You do not need to worry about spending too much of your retirement pot too quickly, you don’t need to worry about a fluctuating investment portfolio continuing to be able to support your required income. You just buy the annuity and you move on with your life - the financial equivalent of bowling with the rails up.
I really can’t think of another advantage of buying an annuity - but there is no denying that this certainty of outcome is immensely attractive to a lot of people.
Without getting too deep, all of us are required to accept an uncertain future. This is just a fact of life. We have an infinite amount of paths ahead of us and none of us has any idea of what lies down the one that we will eventually take.
In this context, having control over at least some element of our financial outcomes can be very tempting.
Disadvantages of an annuity
The trouble with all this certainty is that it comes at a cost.
Let’s look at an example. A healthy 60 year old woman, with a £500,000 pension pot wants an inflation linked income for the rest of her life.
At the moment, she can buy an annuity which pays her £21,276 a year (4.26% of her pension pot). After tax (let’s assume that she has no other income) this gives her £19,535 a year to spend on whatever 60 year old women spend money on.
Fine, great. But what could she have achieved if she chose to keep her pension, and took an income from it each year instead?
The below chart shows the maximum annual withdrawals (adjusted for inflation over time) that a pension account, invested into a simple 60% stock and 40% bond portfolio, could have supported over a range of 39 year periods using market and economic data going back to 1915.
What we essentially have here, with some help from our friends at Timeline Planning, is an idea of what our fictional client “could have won”.
In 88% of the scenarios shown, the portfolio could have supported a higher annual expenditure than that produced by the annuity. You can see this from the amount of grey bars which are higher than the horizontal blue line in the above chart.
Put another way, our fictional client would only have ended up better off buying an annuity in 12% of the historical scenarios shown - and that assumes that the client lives to the age of 99.
“Yes but Dave, have you not been a bit sneaky and not made any allowance for investment costs?”
Fair point - but I also haven’t included any advice or commission cost in the annuity quote. So I am kind of comparing apples with apples.
But let’s add on a 0.5% annual investment cost to the portfolio anyway and see what that does to the numbers.
Making this adjustment, the client would still only have received a higher income in retirement from the annuity just 23% of the time.
What we see therefore is that selling uncertainty comes at a cost that isn’t always obvious.
Just think about it logically, for the insurance company to accept this trade there must be something in it for them.
And there is - the stats tell them that in most cases they will be able to earn a return on your money, in excess of what they have to pay out to you.
The other main disadvantage of an annuity lies in its inflexibility. Once you have locked in the rate, that is it. One income for the rest of your life. Real smart, Frank.
You are probably going to want to spend more in your sixties, than you are in your nineties. When we are younger, those pounds and pence may be able to be put to better (more fun) use.
Annuity income is also rigidly taxable at your marginal rate of income tax. For wealthy folks in retirement this could mean that income gets dinged at a top rate of 40% or even 45%.
Finally, and forgive me if this is blindingly obvious, but once you sell your capital to an insurance company - it belongs to the insurance company. That capital cannot be passed onto future generations, or be used to support causes that you care about.
There is also the, not insubstantial, risk that you die shortly after buying an annuity.
Exchanging all that capital, for very little in return.
As I mentioned above, the decision to buy an annuity is a big irreversible one. Like all big, irreversible decisions it should ideally only be undertaken following counsel with a knowledgeable, empathetic adviser.
I don’t hate annuities, I think they have their place. It is also important to note that this isn’t an “all or nothing” decision. A portion of a pension can be used to generate a secure, known income to cover a client’s necessities - with the remainder of the pension invested to provide for the “nice to haves” over time more flexibly.
The issue that I have with annuities is that a lot of folks just focus on the income quoted, and don’t bother to try and understand the true cost that this certainty of outcome comes at.
There is no such thing as a bad financial decision, only an uninformed one. To make an objective decision we must understand all of the factors at play.
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