Annuities Under the Microscope
Are we in an annuity crisis? For years the annuity has been the linchpin of retirement. The premise is simple: you hand over a sum of money (typically most of your pension pot) to an annuity provider, who then pays you a guaranteed income for life. So what’s the problem?
The problem is that this arrangement has become less attractive over the years. How much guaranteed income you can buy for your money depends on numerous factors, including life expectancy – and of course people are generally living longer. But an even bigger factor is annuity rates. These have fallen dramatically in recent years; for instance, in 2008 a sum of £100,000 could have bought you an income of £7,855 from the age of 65. The same sum today would buy you an annuity of just £4,890.
This doesn’t mean necessarily that annuities are no longer good value – just that they were a lot better value in the past. As we’ll see below, there are other advantages to an annuity beyond the actual sum of money paid out. However, the drop in annuity rates – particularly in the wake of the EU referendum – is a reason at least to look at alternative retirement plans.
If you are searching for a better solution than a straightforward annuity, here are the main options you might want to compare.
We’ll start with the one we hope to beat: a straightforward annuity. Assuming a pension pot of £100,000 and a rate of 4.89%, this gives you the annuity of £4,890 from the age of 65. You will receive this every year for life, no matter how long you live. It’s worth noting that when you pass 85 years and 6 months, you will have received more than the original £100,000.
With a drawdown scheme, your pension pot remains invested and you can draw an income from it. If we suppose the same sum of £100,000 and a conservative average growth rate of 2%, the drawdown pot could provide the same £4,890 a year for 26 years before running out.
Of course, the big selling point of drawdown is its flexibility. You could draw out more than £4,890 a year, at the risk of running out of money sooner. For instance, if you took £5,500 a year (at the same rate of growth), you would run out of money at the start of the 23rd year.
The picture is further complicated by the fact that you might not always draw out the same amount. For instance, if you draw out a large sum during a period of negative growth (these periods will inevitably happen) then your fund will take longer to recover.
As you can see, it’s very hard to predict exactly how well a drawdown scheme will perform for you, as it depends on so many unknown variables – how much you’ll take out, how long you’ll live, how well (or badly) the stock market performs over that time, and how your withdrawals coincide with this performance. This is why it’s essential to talk to a financial adviser when considering drawdown.
Some pension providers offer a halfway house between an annuity and drawdown. These products are generally known as ‘guaranteed drawdown’, though they arguably have as much in common with annuities. You are paid a guaranteed annual income for life, but retain access to the main pot of money so you can draw out more if you need it. However, if you draw out more than your guaranteed minimum income, then your guaranteed income in subsequent years will be proportionally lowered.
Different providers will offer different terms, but you can expect your guaranteed income to be somewhat lower than you could expect from a straightforward annuity – falling further with every year that you exceed it.
Drawdown first, then annuity
With annuity rates so low at the moment, there are arguments in favour of a ‘wait and see’ approach – rather than locking yourself into a low rate for the rest of your life. Pension freedom means that even if you do want to buy an annuity eventually, you don’t have to do it right away. Instead, you could wait a few years, living off your pension through a drawdown scheme in the meantime. There are three reasons why this might suit you:
- Annuity rates may improve in the future
- You will be older (and may have developed health problems) which may result in a higher annuity
- You may have reached state pension age, in which case you’ll have a second source of income.
As in the previous examples, let’s suppose you start with a pension pot of £100,000 which is growing at 2% per year. Let us also suppose that you won’t reach state pension age until 68. If you retire at 65, these means you have to tide yourself over for three years.
If you were to draw down an annual income of £10,000 then by the end of those three years (assuming steady growth of 2%), you could expect to have a remaining pot of around £75,000. You can now, if you wish, choose to buy an annuity. Because you are now older, you can expect a slightly better annuity rate, even if rates in general have stayed the same as before. If we suppose you can now get 5%, then this would buy you an annuity of £3,750 a year. Added onto the full state pension, this would give you a total guaranteed income of just over £11,800.
If annuity rates in general had risen in the meantime, you could expect to receive even more. However, bear in mind that they could just as easily fall – although you’d still have the advantage that comes from delaying until you’re older.
It bears repeating that all of the figures given here are for illustrative purposes only (and also note that examples given above do not factor in the state pension, which may also vary from person to person). It is therefore vital to seek financial advice to suit your particular circumstances. These examples are merely to give you an idea of the alternative options you can consider.
This article first appeared on Unbiased.