Everything you need to know about annuities
This week, we are discussing one of the key questions many people have as they approach their retirement and have to decide what to do with their hard earned savings, or hard earned pension savings, specifically. And that’s the question of whether to buy an annuity or enter into something we call in this financial services-world, drawdown. You can listen to my interview with William Burrows on The Retirement Café podcast here.
What’s an annuity?
An annuity is a policy where you convert a lump sum, a pension pot, into a stream of income. Annuities have been around since the Roman times, so they’re one of the oldest products.
The easiest way to understand an annuity is to think of a mortgage in reverse. Everybody will know what a mortgage is. You borrow money from a bank or a building society, and then you make monthly payments, and each payment is interest plus capital.
Now, with an annuity, it’s the complete reverse. You’re giving money to an insurance company and in return, they’re paying you back your original capital, plus interest.
But the important thing is, the payments will continue for as long as you live.
It’s a betting game
You could think of it as a bet against the actuary. If you’re 65, they may say, well, we’ll give you another 25 years. So, if you live to be 100, you’ve more than won the bet. If you die in your 80s, then they’ve won the bet.
There is this pooling and technically it’s called mortality cross subsidy. So those that die earlier subsidise those that live longer.
The insurance an annuity provides is against living a long time. Or as the Americans say, it’s insurance against outliving your assets.
How an annuity works
Annuities are priced on returns from gilts and bonds. Now, returns on bonds and gilts have fallen like a stone. So, if you take my mortgage in reverse example, people are getting their own capital back, but the interest rate on top is very low. I would sort of guess that the implied interest rate is probably less than 2%.
Why annuities have fallen out of favour
One factor that makes annuities less attractive is that the annuity dies with the policyholder. If people are married, they would normally have a joint life annuity, so it carries on until the spouse or partner dies. But at the end of the term, there’s no lump sum investment.
A lot of people want to leave an inheritance. The main thing about pension freedoms is it’s given people the choice, the option to leave money to the children.
However, bear in mind that once you’ve purchased your annuity, you will get that payment forever and a day, without having to worry about what interest rates do, what stock markets do, et cetera. Of course, that’s a real benefit.
But what about inflation?
Inflation is like sin, every government denounces it, but they all practise it. If I just give a simple example: take £100,000. 5% would be £5,000 – that’s the key figure, that’s what you used to be able to get for a single life level annuity as an annual income.
So, you give an insurance company £100,000 and in return you get £5,000 a year back, but that’s a level payment that doesn’t increase. If you want to have inflation proofing, you start off at £3,500, and then that will increase with inflation.
You can see from that example it’s going to take a long time for the increasing annuity to catch up with the level annuity.
If you were a 65 year old male buying an annuity today, either the level one or the index linking one, how long do you have to live to get your capital back, or to break even? The crossover point is about 15 or 16 years. After this point, you’ve ‘won the bet’.
The health factor
It’s worth considering how your health and your social factors come into annuity pricing.
They make a lot of difference. An annuity is priced on both the interest rate and how long the insurance company think you’re going to live. So, if you’ve got a heart complaint, or you smoke, the chances are you won’t live to your normal life expectancy. In that situation, the insurance company will give you a boost. It’s called an enhanced annuity.
Enhanced annuities just pay out a higher income for those people who are in poor health. . But there’s a really important point with this. There’s no free lunch here.
So, if I give some figures; you can probably get 10% more income. If you smoke, you might be able to get 20% or 30% more income, similarly if you’ve got a cancer or a heart disease, but there’s no free lunch. All the insurance company is doing is accelerating the payments back to you. So, actuarily, they’re what you’d call neutral.
When’s the best time to buy an annuity?
Annuities are priced on this concept of mortality cross subsidy. So, if you’re 60, the benefit from the mortality cross subsidy is relatively small. Once you get into your 70s, it starts to become meaningful. And then certainly, by the time you get to 75 or 80, it’s really quite significant.
The optimum time to buy an annuity used to be in old age, whenever that was – 60 or 65, but that’s no longer old age – we’re looking more like 70 or 75.
And then if you combine that with what I call de-risking your pension pot, then I think it makes sense. If you’re in drawdown and you start getting into your 70s, you want to take less investment risk. There’s more benefit from the mortality cross subsidy. Peace of mind and security becomes more important to you. That’s the time you should think about converting monies into annuities.
Starting with your objectives
As a financial planner, I’m sure you’ll agree, it’s not about the product, it’s about people’s objectives. And I think the hardest part of what I do is not explaining the annuity options, because that’s relatively straightforward. The really difficult thing is getting people to be clear about what their objectives are.
I say to people, I don’t want to put words into your mouth, but if you turn around and tell me that what you want is a sustainable income, in real terms, keeping pace with inflation, without taking undue risk, leaving an income to your partner, if you die first. Now, you unpack that, that probably equates to an annuity. But of course, a lot of people start off by saying that they want freedom, a bit like Brexit; give me control, I want control and I want freedom.
But of course, freedom isn’t licence. So just because you’ve got pension freedoms, it doesn’t mean that you should spend your money unwisely. So, we’re back to an annuity, because it’s the only policy that will pay a pension, a guaranteed income for life.
It’s important to shop around to get the best rate. But it’s even more important, in fact, that you ask yourself, is the annuity the right thing for you? Have you got the right options? Are you buying it at the right time?
People don’t realise they haven’t got to put all their eggs in one basket. So, you don’t have to put all of your money into an annuity. There’s no reason why you can’t, what I call, fade your annuities; buy it over time.