In praise of annuities
This much-maligned product should remain a centrepiece of retirement planning.
Until 2006 it was compulsory in the UK to use your pension pot to buy an annuity. Progressive relaxations of the rules have brought us to a position where not only is buying an annuity optional, but you have complete freedom to take your fund as and when you like (subject to paying tax). Since 2006, annuity rates have fallen by close to one-third in response to falling interest rates, making annuities seem ‘expensive’. Absurdly generous inheritance tax treatment introduced in 2015 has made it much more attractive for wealthy retirees to spend their pension as a last resort.
A shrinking market
As a result, the annuities market has taken a hammering. According to the Financial Conduct Authority, annuity purchases have fallen dramatically, from 462,000 in 2009 to around 80,000 in 2019/20.
A quick look at the numbers explains why annuities are so unattractive. According to Hargreaves Lansdown, at the time of writing a 55-year-old single person with a £1m pension fund can only buy an inflation-linked income for life of around £17,500. That’s £57 for each £1 of pension bought! According to the Office for National Statistics, the life expectancy of a 55-year-old man is 84, so 29 years. An annuitant living to their expected age would have got barely half their money back in real terms (the situation is slightly better for a woman, but not by much).
By contrast, according to analysis by retirement planning specialist Abraham Okusanya of Timeline, a fund of £1m invested 60% in UK stocks and 40% in government bonds would have supported an inflation-linked retirement income of £32,000 pa over at least 30 years over any period starting since 1900. And this includes a 1% pa fee allowance for advisers managing the portfolio. That’s nearly double the amount from the annuity.
When the so-called safe withdrawal amount from a portfolio of stocks and bonds is so much more than the income from an annuity, the decision seems a no-brainer. When added to the inflexibility of an annuity and the attractive inheritance tax treatment if money is left in the pension fund, it’s not surprising that almost everyone is now using drawdown rather than annuity purchase when they reach retirement.
If it seems too good to be true, it probably is
This analysis ignores an important component: risk. Of which there are four important dimensions:
1. Unknown unknowns
A 60/40 UK portfolio of £1m has supported withdrawals of £32,000 per year for 30 years for every period since 1900. But this doesn’t mean it will in the future. In fact, since the date most financial market data sets start, at the beginning of the 20th century, we’ve only had four independent (i.e. non-overlapping) 30-year periods. Not a large dataset. Yes, a lot has happened in the 20th century, but who knows what may be to come. Markets price in insurance for the unknown as well as known. Just because something hasn’t happened in the past doesn’t mean it won’t happen in the future. My house has never burned down but I still buy buildings insurance. We should be prepared to pay a premium for a contract that protects against extreme and unforeseen eventualities.
Risks aren’t just financial. What if your platform provider goes bust? In theory assets are segregated but what if, in fact, they weren’t? And in any case receivers can claim against the assets held to pay their fees. It’s a little-known fact that while assets in drawdown in a SIPP are only protected by the Financial Services Compensation Scheme up to £85,000, annuities in payment are protected in full.
The life expectancy of a 55-year-old man may be 84, but there’s a 1 in 4 chance he will live until 92 and around a 1 in 25 chance he will live to 100. A drawdown fund may need to last 45 years not 30. An annuity never runs out.
Indeed, investment in an annuity provides a mortality uplift, if you’re one of the survivors. You share in the spoils that the dead leave behind. This becomes more pronounced with age. Instead of a 55-year-old take a 65-year-old. Now Hargreaves Lansdown tells us a £1m pot purchases an inflation-linked income of £28,500 (or a flat income of £49,000!) just 10% below the safe withdrawal amount. A 65-year-old has a 10% chance of living to 96, out-surviving the 30 year drawdown ‘guarantee’. A 10% income reduction to remove a 10% chance of an improverished future doesn’t sound so bad.
Buying an annuity, at least for later years, has further benefits. First, it’s well known that cognitive capability declines with age. The peak age for financial decision making appears to be between 50 and 55. Competence then decreases monotonically with age, and at an accelerating rate.
Will we want to be managing complex drawdown issues in our eighties? Having a monthly income secured by an annuity coming into our bank account will help keep things simple for us and lessen the chance of costly mistakes.
A plan’s no good if you can’t stomach sticking with it. Safe withdrawal rates are all very well until you look at what you would’ve had to put up with over the drawdown period. Suppose you started drawdown in 1968 with a pot of £1m taking out the ‘safe withdrawal’ of £32,000 a year. By 1984, barely halfway through the supposedly safe 30-year period, your fund would’ve fallen to under £0.3m in real terms. In other words, nearly three quarters of the fund gone in half the time.
As it happens, exceptional real returns of 11% pa on a 60/40 portfolio over the bull market of the next 15 years were just strong enough to rescue the situation and the fund squeaked over the line, lasting for 34 years in total. But would you really have been able to hold the course in the early 1980s? Guaranteeing a minimum baseline allows you to remain aggressive with the remainder of your portfolio, knowing that if the worst happens you won’t starve.
What price piece of mind?
Wealth managers make more money from drawdown than from annuities. They can charge you a handsome 1% a year for managing the complexities of a drawdown portfolio. There’s little incentive for them to direct clients who are already sceptical about annuities towards this option.
But perhaps they should. As a successful professional you’re in a fortunate position: you have a margin. You can likely survive on significantly less than your target income. But this doesn’t mean you should be reckless with risk. And there’s a great comfort to be had in knowing you’ve closed off the worst that could happen.
Annuities have got a bad press, which they don’t deserve. For successful professionals they are unlikely to be the whole story. You will want liquidity and flexibility for a significant portion of your assets. But an annuity could well provide a worthwhile home for between a quarter and half of your portfolio. A possibility to put to your adviser.
Nothing in this article should be taken to represent financial advice. It is generic commentary based on typical circumstances and not tailored to your own situation. If you’re not sure what to do, you should take financial advice.