Are annuities still relevant to investors and how much could you get?
In 2015, sweeping reforms gave people over 55 unlimited access to their pension schemes for the first time, and prompted Steve Webb, the pensions minister at the time, to suggest pensioners could blow their cash on Lamborghinis if they wanted.
There hasn’t been a noticeable proliferation of supercars on the streets of retirement havens like Eastbourne, but there has been a significant shift in how people draw on their pensions. In particular, sales of pension annuities, previously the most common way to draw on a pension, have fallen off a cliff.
WHAT IS AN ANNUITY?
Prior to 2015, the main way you would draw on your pension was by buying an annuity. In exchange for the lump sum you had built up in your pension, insurers would pay you a set amount every year for life.
Insurers combine investments in fixed interest products with their expertise of mortality trends, to calculate how much to pay out to members, plus a little profit for themselves.
WHY ARE ANNUITIES NO LONGER POPULAR?
It’s probably fair to say that even in their heyday, pension annuities weren’t ‘popular’ as such. People bought them reluctantly, mainly because the alternatives were expensive or complicated, or both.
Many people objected to the fact that if they die only a few months or years after taking out an annuity, all the money they have spent their life building up is gone, at least as far as they and their beneficiaries are concerned. It is a fair point.
However, pension savers probably failed to fully appreciate the flip side of the coin, that if they were still going strong at age 100, their annuity would still be providing them with a regular income.
When the pension rules changed in 2015, the stage was set for annuities to take a back seat, as people simply drew their pension as cash, or invested it and drew an income from bonds and shares instead.
Low interest rates have also made annuities look unattractive. Insurance companies invest most of the money they get from selling annuities into government and corporate bonds, and these provide the returns annuity members effectively share.
As interest rates have sunk, so have the yields on these bonds and consequently so have annuity rates.
HOW MUCH COULD I GET?
A standard annuity for a 65-year-old will now offer you an annual income of around 4.5%, so for each £100,000 you provide to an annuity company, they will provide you with an income stream of £4,500 every year, for the rest of your life.
That compares with a rate of around 7% before the global financial crisis of 2007/2008 and the introduction of ‘emergency’ interest rates, which were, remarkably, higher than they are today.
If you compare this with an investment portfolio, it’s easy to see why people are taking advantage of the new pension rules which let people aged 55 and over access their defined contribution or money purchase pension pot in whatever way they want.
An equity income portfolio will probably deliver a yield somewhere in the region of 4%, though unlike an annuity, investment income is variable, and will go down at some points such as we saw in early 2020.
But unlike an annuity, you also keep hold of your capital, and over time, you would expect the dividends in your portfolio to grow with company earnings.
SHOULD I BUY AN ANNUITY?
At the moment buying an annuity with your pension means locking into low interest rates, but there are some circumstances in which you might wish to do it.
One thing an annuity does offer is certainty. It might not pay out a king’s ransom every year, but what it does provide is guaranteed for the rest of your life.
You do need to be wary of the effects of inflation. If you opt for a level annuity with a fixed payment every year, rising prices will gradually eat into its buying power, and because an annuity can run for 20 or 30 years, possibly more, that effect can be extremely potent.
You can buy an annuity which pays out an inflation-linked income, but this will start at a lower level. For example, currently a 65-year-old could expect about 2.8% from an annuity that rises each year in line with the RPI measure of inflation, compared to 4.5% from one which simply pays a level amount for good.
You might also consider buying an annuity if you’ve got health issues. Some insurers offer enhanced annuities, which provide higher levels of income for those who have certain health problems that are likely to reduce their life expectancy.
These don’t have to be life threatening conditions; you can apply for an enhanced annuity if you have high blood pressure, diabetes, or are a regular smoker. An insurance company might give an uplift to your annuity income of 10%, maybe more, depending on your circumstances.
IS IT WORTH SHOPPING AROUND?
If you do decide to buy an annuity, make sure you shop around for the best rate. As with many insurance products, the path of least resistance is likely to be the costliest, so don’t simply accept the first annuity you’re offered by your pension provider.
After all, this is a one-off transaction which will affect you for the rest of your life, so it’s much more important than shopping around for car or home insurance.
Also bear in mind that you don’t have to choose between an annuity and investing your pension to provide an income, you can split your pension pot and do a bit both.
By mixing and matching, you can secure a base level of income using an annuity and invest the rest to hopefully provide a variable stream of dividends that should hopefully grow in the long term.