We’ve been looking more closely at annuities recently for our clients, as rates have been gradually rising. Annuity rates are at their best level since 2015, having reached a low point in August 2016, with a spike in rates since the beginning of the year (see (1) below for source of information).
An annuity is a contract where you give a lump sum to an insurance company and that company pays you an agreed income for the rest of your life, regardless of how long that might be (2). The catch is that, when you die, the insurance company keeps the money you give them. So, an annuity is good value if you live a long time, but poor value if you only live for a few years after buying it. Just a few years ago, you were obliged to buy an annuity with your pension fund at some point, but this is no longer the case.
The best rate for a man aged 66 today has increased to 3.77% (this is for an annuity which increases with inflation every year) (3). For a joint life annuity (which continues until the second death of the annuitant and their spouse), the best rate is 3.01% (4).
According to Timeline (a company which stress tests retirement plans), the average life expectancy of a 66 year old man is 22 years, with a 10% chance of living till 97. As regular readers will know, if you live in the South East and you are affluent, your life expectancy should be above average. For a man and woman, who are both aged 66, there is a 50% chance that one of them will live till they are 92, and a 10% chance that one of them will be alive at 100.
Based on these figures, you can see why an annuity might look attractive. An income guaranteed for life by an insurance company is valuable, and could take away many of your worries.
Timeline is a very useful tool, and it allows us to stress test theoretical as well as real plans, using historical data, going back to 1915. We asked it to stress test an investment-linked pension fund of £100,000, which was paying out an income of 3.01% per year, increasing in line with inflation. We used our standard medium risk portfolio asset allocation and assumed an annual charge of 1.75% per year of the value of the pension.
For the investment-linked pension, Timeline told us that there was no period since 1915 when the pension would have been exhausted. The period includes two world wars, the Great Depression, and, perhaps, most interestingly in the current climate, the 1970s and 1980s when inflation was high. We have to increase the spending level to 3.39%, before there is a 5% chance that the pension fund would be exhausted in our theoretical couple’s lifetimes.
The simple conclusion is that the guarantee of a lifetime income provided by an annuity is only going to be needed if the returns from investments are worse than they have been in the last 107 years, or inflation is higher than it has been in the last 107 years.
But is that right? Let’s imagine that our theoretical couple aren’t risk takers at all, and wouldn’t be happy with the risks of our standard medium risk portfolio. Instead, they are only prepared to hold cash in their pension fund. We reduced the charges to 1.25% per year (as there aren’t usually any fund management charges on cash) to make for a fair comparison.
For this theoretical couple, there is a 5% chance that the pension fund would be exhausted if they start by spending 1.74% per year of their pension fund, and increase it by inflation. This is the result of the returns from cash having been lower than the returns from investments over the last 107 years. However, we believe that you should not force yourself to take more risk than you are comfortable with, so, if you would be unhappy about the fluctuating value of investments, you should stick with cash deposits.
What we can conclude is that the value of the guarantee of a lifetime income which an annuity provides is much higher, if you are risk averse. The rise in annuity rates may mean that annuities are already attractive to you. Investors with a low to medium risk outlook might also find the annuity guarantees attractive too.
This is only a short blog post, so it massively simplifies the decision about an annuity purchase. Annuities aren’t flexible, and the pattern of most retirees spending doesn’t follow the annuity income options available. Some people can get better annuity rates if their life expectancy is considered to be lower than average (for example, if they smoke or have type 1 diabetes). Alongside the state pension and other guaranteed pensions, they can be a good way of providing for your unavoidable expenditure. Taking advice, forecasting future cashflows and stress testing are some of the first steps you should take before deciding on how you go about generating an income, so you certainly shouldn’t rush into decisions about annuities.
It’s hard to know what will happen to annuity rates in the future – rates tend to be linked to life expectancy, long-term gilt yields and the amount insurance companies charge. If all else is equal (they rarely are!), and long-term gilt yields carry on rising, annuity rates could rise further. But any rise in gilt yields could be negated by an increase in life expectancy or insurance company charges.
Annuities have always been an option for people seeking to generate an income for their retirement, and, after years of being unattractive, they are beginning to look like a reasonable alternative, for the right people.
If you would like to know if you should buy an annuity, please contact us.
Philip Wise | email@example.com
Managing Director and Chartered Financial Planner
This guide is for information purposes and does not constitute financial advice, which should be based on your individual circumstances.
A pension is a long-term investment, the value of your investment and the income from it may go down as well as up. Your eventual income may depend upon the size of the fund at retirement, future interest rates or annuity rates at point of purchase and tax legislation.
The level and bases of taxation, and reliefs from taxation, can change at any time. The value of any tax relief depends on individual circumstances.
(1) Data about annuities sourced from Sharing Pensions, on 3rd June 2022 (based on Sharing Pensions’ benchmark example for a 65 year old, in good health, single life pension annuity which doesn’t increase and stops immediately on death, and an annuity purchase price of £100,000).
(2) Some annuities run for a specific period of time but there are less common
(3) Based on a single life, in good health, pension annuity which doesn’t increase and stops immediately on death, and an annuity purchase price of £100,000. Data sourced from Iress portal on 29th June. Example assumes no commission of adviser fee.
(4) Using the same assumptions as (3), but assumes that the annuity is for a man and a woman, both aged 66.