annuities

Many people wrote off annuities due to the abysmally low rates on offer in recent years. Lifetime annuity rates are driven by long-term interest rates, which had been in steady decline until recently. But now short- and long-term interest rates are on the rise again. This has dramatically pushed up annuity rates, in many cases by 40-50%. Over the last year this has translated into 40-50% more guaranteed income for every pound invested. So if a year ago your pension pot could have bought an annuity income of £5,000 a year, now the same pot could buy from £7,000 to £7,500 a year. Many people are therefore now looking at annuities again.

Annuities versus drawdown

It’s actually wrong to frame the decision as all-or-nothing. Annuities and drawdown can exist quite happily side by side. Intuitively, it might make sense to use guaranteed income to cover all essential spending, and drawdown to fund discretionary spending. If that can be achieved, then the chance of running out of money is zero, since it’s always possible to cut down on discretionary spending if necessary.

But what if you really want to avoid the need to cutdown on discretionary spending? Then maybe you could use annuities to fund at least a portion of your discretionary spending as well. This sounds great in theory, but how do you know how much of your pension pot you should convert into annuities?

The 4% rule is a popular rule-of-thumb. It says that if you draw down 4% of your pension pot in the first year, and adjust withdrawals each year thereafter by inflation, you have a very low probability of running out of money. Let’s leave aside the serious questions over the accuracy of the 4% rule. Assume for simplicity that you’re single, and that with a 4% inflation-adjusted drawdown rate you have a 5% chance of ruin. So if your pension pot is £100,000, you can draw an income of £4,000 a year.

Now suppose you check out annuities, and discover that you can buy an index-linked annuity (with no guarantee period) having a rate of 4%. This would also generate an income of £4,000 a year. Should you go for the drawdown or the annuity?

If you’re not interested in leaving a legacy, then the decision is a no-brainer. You should buy the annuity, since you get the same income with no risk. If you’re hoping to leave a legacy, then it depends on how important that is to you, in comparison with the risk of ruin. Is a 5% risk worth taking on behalf of your heirs? Taking that risk with drawdown wouldn’t guarantee you’ll leave a legacy, but would make it probable. A 50-50 mix of annuity and drawdown income would have a 2.5% risk of ruin, and the potential legacy would be cut in half; maybe some kind of mix would work best for you.

Different types of annuity

The example of choosing between drawdown and index-linked annuities is relatively straightforward. But index-linked annuities are expensive. In round numbers, £100,000 could buy you a level annuity (the income never changes) of around £7,000 a year; but an index-linked annuity would start at around only £4,000 a year. You can also buy annuities whose incomes go up by a fixed percentage each year; the prices for these depend upon the chosen percentage.

Choosing between drawdown and these different types of annuity is very complex. There’s no one-size-fits-all strategy, or simple rule-of-thumb. For some, index-linked annuities may be best. For others, level annuities might be best, with top-up purchases in future years to increase the guaranteed income. Alternatively, for yet others, annuities increasing by a fixed percentage might be best. The right strategy depends on personal circumstances, the prevailing mix of available annuity rates and the prospects for inflation.

Don’t rule out annuities

If you’ve previously ruled out any possibility of buying annuities, now or in the future, now is a good time to rethink. The main reason you may have done so is that leaving a legacy is important to you. But paradoxically, sometimes the judicious inclusion of annuities can increase your likely legacy, by de-risking your portfolio.

Our own intelligent retirement calculator is able to optimise how to balance between drawdown and annuities. It has a feature enabling one to rule out annuities altogether, but we advise against using this. The optimiser would in any case avoid annuities unless they produced better outcomes in line with attitudes to risk and leaving a legacy. Ruling out annuities means the optimiser may not consider strategies that would have given better outcomes.

Annuities Are Making A Comeback

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