Are annuities a bad deal?

For a long time, many people have been unaware of the choices open to them at retirement and simply purchased the annuity (an insurance policy that pays a guaranteed income for life) offered to them by their pension company. After the recent Budget, the danger now is that too few people will buy an annuity of any description, even though, it remains a sensible option.

The failure of people to shop around at retirement is certainly an issue. In 2013 one in every two people who bought an annuity bought it directly from their existing provider, despite the fact that default annuity payments can be 20% lower than the best available rates.

There are major reasons why annuity payments have fallen so much in the last few years. Firstly, people are living much longer, which means the annuity provider has to stretch the same payments over a longer period, and secondly, interest rates are at all-time lows.

In the 1960s a man in the UK hitting the retirement age of 65 could expect to live for a further 12 years. Now that figure is 19 years (and 21 years for women)and many people will live for much longer.  It is not inconceivable that some people will spend as long in retirement as they did working. Life expectancy will continue to increase and, from the annuity provider’s perspective, any lifetime income guarantees must include ‘longevity risk’.

Annuity rates are also based on the rate of interest insurance companies can obtain from safe investments such as UK government bonds. In the current economic environment, it’s no surprise that annuity income payments remain low (and are likely to remain so), but this doesn’t make them poor value.

Under new rules announced in the Budget, from April 2015 your pension fund can remain invested and money can be withdrawn at any rate you choose.

This flexibility is very welcome — most people’s income requirements won’t remain constant throughout their retirement and, in contrast to an annuity, any remaining funds can be passed on to the next generation (although taxable). Managing a pension fund to ensure that you don’t run out of money will present a testing new challenge.

Based on a diversified portfolio of investments containing 60% equities and 40% bonds (and some reasonable growth assumptions), a withdrawal rate of 6% of the initial sum invested would be sustainable for 20 years. A 5% withdrawal rate would see you running out of money after around 26 years.

It’s inevitable that some people will be tempted to withdraw funds at a higher rate, which only works if a better investment return can be achieved (or you die young). Yet many do not realise the risks involved in investing a higher proportion of their accumulated wealth in the stock market. The administration, investment and associated advice costs of income drawdown also need to be considered and may be unduly high for anyone without a considerably sized retirement pot.

In comparison, a competitive annuity is currently offering a fixed lifetime income of around 5.6% for a healthy 65-year-old, with 50% of this then payable to a partner of the same age. At age 75 the comparable rate is 7.3%.

Of course, buying an annuity also involves risk. A fixed-rate income might be consumed by rapid inflation. Conversely, an inflation-linked annuity with a reduced initial income may be an expensive mistake if inflation is lower than expected.

Despite the bad press, annuities remain an important part of the retirement income puzzle for many risk-averse and older investors.

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Ian Thomas is authorised and regulated by the FCA. This article is intended to provide helpful information of a general nature and does not constitute financial advice.

Article is accurate at date of writing.