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, some people choose to use guaranteed income to cover essential spending, and drawdown to fund discretionary spending. If that can be achieved, then the calculated risk of running out of money becomes negligible, since discretionary spending can be reduced 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 do you determine how much of your pension pot might be converted 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. How might you compare drawdown with an annuity in this situation?
If leaving a legacy is not a priority, an annuity may appear attractive because it provides the same income with no investment 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; a mix may produce different trade‑offs between risk and legacy.
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 align better with their goals. For others, level annuities may align better, with top-up purchases in future years to increase the guaranteed income. Alternatively, for yet others, annuities increasing by a fixed percentage may align the best. The preferred approach 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 may be a time to revisit the question. The main reason you may have done so is that leaving a legacy is important to you. But paradoxically, sometimes including annuities can increase the modelled likelihood of leaving a legacy, by de-risking your portfolio.
Our own intelligent retirement calculator is able to generate strategies that balance drawdown and annuities. It has a feature enabling one to rule out annuities altogether, but note that using this option may prevent the model from exploring certain strategies. The strategy generator would in any case avoid annuities unless they produced outcomes better aligned with attitudes to risk and leaving a legacy. Ruling out annuities means the generator may not consider strategies that would have produced such outcomes.