Pensions and retirement: What are your annuity options?
An annuity pays a guaranteed income for life and is mainly used by those with private pension policies when they convert their accumulated funds into income.
Annuity rates determine the amount of pension income that can be bought with this private pension pot.
The falls in annuity rates have been so severe over the past few years that many investors are barely getting their money back from annuities if they live to their normal life expectancy.
However, there are various options available for those approaching retirement.
Getting a return
Take the example of a man aged 65 living in the middle of Britain with £30,000 to invest in an annuity.
He would get £1,719 a year gross for their rest of his life. Put another way, after 17 and a half years the original will have been paid back, so if he had died before then he would have lost out financially.
If he lives to age 85, he would have earned a profit on his investment of £4,298. That is two and a half years worth of annuity payments.
On the bright side if he lives well past his normal expectancy he will have made a significant return on his money. This highlights the advantage of the mortality cross subsidy within annuities. That is those who die early subsidise those who live longer.
The reason for falling annuity rates is simply that the yields on gilts - or government bonds - which are the benchmark for annuity pricing have fallen to an all-time low.
On 3 August, the yield on 15-year gilts fell to 2.02% compared to 2.75% just four months ago. Consequently, all the major annuity providers cut their rates again.
There has been a consistent fall in annuity rates since 2007.
So what does this mean for those approaching retirement?
Apart from the obvious fact that the amount of guaranteed income paid that can be purchased from a pension fund is at the lowest level ever, it means that investors need to consider their options in more detail than ever before.
Some people have more choice than others because of the size of their pension pots. It is necessary to look at the options for those with different sized pension pots, assuming the average pension fund at retirement is valued at only £30,000.
People with below average sized pension pots account for the largest number of private pension policy holders. They have the least realistic choice and arguably get the worst deal.
This group have an option to:
- Take tax-free cash, and purchase an annuity
- Defer taking tax-free cash, and purchase an annuity
- Take the tax-free cash now, but purchase an annuity later
- Invest in a fixed term or investment linked annuity
There are various advantages and disadvantages to all these options. For example, there is no guarantee that annuity rates will improve if this decision is deferred.
There are three golden rules for investing in annuities, where there is a risk that the income could be lower in the future.
Firstly, people should have other sources of income or capital to fall back on if the future income falls in value.
Secondly, all the relevant risks should be explained by a provider and people should confirm they understand and accept them.
Thirdly, investors should have considered all the options that may be suitable for them.
People with above average sized pension funds have more options to chose from. This includes pension drawdown - when income is taken from a pension while it is still invested - and taking retirement in phases.
Taking a risk
To conclude, if annuity rates fall much lower they will defy gravity. This is because the natural floor should be the point where annuities simply repay the original capital to investors who live to their normal life expectancy.
Gilt yields and annuity rates may rise in the future but people may have to wait several years for this to happen. Do not defer your annuity purchase for a few months hoping it will get better, because it may get worse before it gets better.
There are other options, other than a guaranteed annuity, but these do carry risk and taking a modest amount of risk may not be a bad thing.
Those approaching retirement are facing the "risk paradox". Put simply, many people think that investing in a guaranteed annuity is the lowest risk option and, in the sense that the income is guaranteed not to change, it is risk free.
But looking to the future, the risk is that the spending power of an annuity will be eroded by inflation, and personal circumstances may change.
Investors may have to take some risk with their annuity income in order to end up in a better position. This is a hard message to sell and full of potential dangers but it is an important message that deserves more debate and analysis.
Finally, in times of so much uncertainty it might make sense not to put all of your eggs in one basket and spread your risk. We call this a portfolio annuity and this can range from a simple combination of guaranteed annuities to a more complex solution including drawdown.
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