Since the pension freedom reforms were introduced in April 2015, far fewer people have bought annuities. The decline has been steep as retirees prefer to access their savings with greater flexibility. Additionally, since the financial crash in 2008, annuity rates have been squeezed since they are linked to interest rates and bond yields which are both at historically low levels.
But annuities are still being bought because they play a role in retirement planning. So what is the case for buying one with all or some of a pension pot?
Well simply put, the income is guaranteed to be paid for as long as you are around, so you don’t have to worry about investment performance, falling stock markets and so on.
The importance of shopping around
But if you are going for the annuity option, it is vital to shop around. The pension provider you have been saving with may not offer the best deal. Many consumer groups have focused on the mistake people often make which is to buy their annuity from this provider without considering alternatives. The variation between providers can be staggering. For example, a 65 year old with £100,000 in their retirement pot to buy income can see a variation of between £354 per month at the low end and £391 per month at the upper end. Choosing unwisely would lose you thousands of pounds in income over your lifetime.
What are the key disadvantages of annuities?
Again simply put, once you have made your choices and handed the pension pot over there’s no going back. So if your circumstances change you cannot adapt.
What are my alternatives?
You can leave your pension fund invested and draw income that you need to live on. There are various options, some easy to understand, others less so. These options are collectively called income drawdown. They allow you to vary the income to suit your changing needs.
I will acknowledge that there are other “third way” products, but that’s for another article.
What is the key disadvantage of income drawdown?
Again simply put, it’s the risk of running out of money before you run out! You might draw too much income out or your investments might not perform as expected.
Can my family inherit my pension?
Well with annuities, that depends on what options you chose at outset (see below). Did you choose to leave benefits to your spouse/partner? With income drawdown the pot that you haven’t spent can be passed down to loved ones.
Do I have to choose between an annuity and income drawdown?
No, you can have both. You might decide that some guaranteed income is desirable to cover let’s say your essential expenditure: utilities, housing costs and food. Then you could use income drawdown to cover other desirable spend items such as holidays. This way you can build certainty around your fixed costs and have flexibility around your variable spending.
What are the current trends?
Many people are currently taking their retirement benefits by income drawdown. Why? Mainly because the annuity rate is historically low and looks poor value to most. A second reason is the ability to pass the pension wealth down to loved ones.
So are annuities dead?
No! If you don’t want the investment risk, and want absolute certainty of income, then annuities certainly have a place for all or part of your retirement pot. Everyone can avoid annuities if they wish, but it is foolish to forget the value of a guarantee.
Annuities – the essentials
What is an annuity?
It’s an insurance product that provides you with an income in exchange for a lump sum of money typically that comes from your pension pot. The level of income that you will receive is determined by the underlying annuity rate. This rate is determined by the annuity provider but generally it’s determined by factors listed below, with the rationale.
How old are you?
Why? So they know how long you are expected to live, as the longer you live the more income is paid to you.
Where do you live?
Why? They can tell if this is a healthy affluent area versus less affluent area. This helps the provider understand how long you are expected to live.
What returns can be expected in a reasonable safe way?
Why? So that the annuity provider doesn’t run out of money as they will be funding this income for as long as you are around, and possibly your dependents.
But there are various options open to the annuity shopper. Here they are with a brief explanation.
Level income or escalating income.
So will your income payment remain the same throughout your lifetime, or will it increase to combat the eroding effects of inflation? Remember that in 2007 a pint of beer broke the £2.50 barrier* Today an average pint is £3.10**
Your decision here may well depend on whether you have other assets to support your “retirement pay rises.”
If you are married or in a civil partnership, ask yourself if you want your spouse/partner to benefit after your death, if so at what amount? Typically this can be 100% of your pension, 67%, or 50%. This is because your partner will either need the same level of income as you took originally or you may decide they could survive on a lower amount.
You can choose to ensure that your income will be paid, even if you are not around to collect it. Typically this will be set at either 5 years or 10 years, but can be for any period you choose providing another valuable guarantee.
**Source: Friday night around the town!