Pensions - Annuities, a thing of the past?
The annuity is dead, long live pension freedom! Or is it?
Almost before the ink was dry on the 2014 Budget, the swords were out and the humble annuity was declared to be dead. Who on earth would want an annuity when they could have one of the new, drawdown contracts, replete with all their options?
The more clients we see however, the more contradictions arise. There is overwhelming evidence (from national studies as well as from our own face to face conversations with clients) that one of the most important things people want in retirement is a guaranteed income. The paradox is that when asked about annuities, they are less keen.
So, what is going on and how should it shape your decision making?
The increased freedoms at retirement have allowed investors to design their own retirement income strategy. At the moment, this means that annuities are being ignored in favour of Flexible Access Drawdown with barely anyone asking about them, but is this the right thing to do?
For all the potential benefits represented by flexible access drawdown, it remains a risk based solution and does not satisfy the ‘guaranteed income’ test. So, how much of a risk are you actually taking? The number of variables makes this an impossible question to answer but it is instructive to look at the Australian experience.
Since 1992, Australians have been able to take their whole pension fund, as cash, from age 65 and consequently, the annuity market is tiny. In the last few years however, a trend has been appearing…people are running out of money. In response, there have been calls for a return to annuity type contracts. This could be the picture in the UK in the not too distant future if we experience the same scenario.
What is wrong with annuities?
It is fair to say that annuity rates in the UK are very poor at the moment and it would be difficult to persuade anyone that, given the alternatives, annuity purchase is the right thing to do however, if investment returns collapse the story might be different. It is all too easy to project a safe and secure income with a stable or growing pension fund based on the premise of positive investment returns. None of the modellers I have seen allow for a period, or periods, of falling or stagnant markets. And this is the part that worries me. Stock markets are by nature, cyclical and experience periodic peaks and troughs. If you plan your retirement strategy based on the premise of constantly rising investment returns, you might come unstuck. There does not seem to be any software out there to support variable returns so it suggests caution is the watchword or alternatively, some sort of ‘smoothed’ investment return might be appropriate.
Another option is to design your strategy around a combination of annuity and flexible access drawdown (FAD). Cover the basics with your state pension and an annuity, then use FAD for the residual amount.
While standard annuities represent poor value in the current market, this combined strategy could be viable if you qualify for an enhanced annuity. Enhanced annuities, offer better rates if you smoke, are overweight or are in poor health. Individually underwritten, and sometimes offering very attractive rates, they can make the decision less of a binary one.