deal-or-no-deal-annuity

Buying an annuity with your pension savings used to be automatic once you retired. Over time, annuity rates got steadily lower. Some retirees were able to opt for income drawdown instead, leaving their pension pot invested. Even then, they had to convert their investments into an annuity by age 75. Then came Pension Freedoms in 2015. After this, nobody was forced to buy an annuity any more. It’s now a matter of choice for everyone.

Annuity popularity in decline

There’s no question that Pension Freedoms dealt a blow to the annuity industry. A 65-year-old retiree be able to get an index-linked annuity rate of (say) 3%. For a £100,000 pension pot, that would generate a pension of around £3,000 per year, rising each year with inflation.

To many people, including financial advisors, the drawdown alternative seems more attractive. Based on history, by investing a large portion of the portfolio in the stockmarket one might anticipate average long-term returns (income plus growth) of upwards of 8%. Of course, returns in any one year could fluctuate, and even be negative. The popular 4% rule suggests a safe drawdown rate of around 4% of the initial portfolio, rising each year with inflation. This would mean a starting pension of around £4,000.

The nature of the choice

The 4% rule was, and is, a simplification. However it nicely illustrates the dilemma, when compared to the index-linked annuity. Should you retire with a smaller guaranteed pension (£3,000), or with a larger pension where there’s a small risk of running out of money (£4,000)?

In reality, it’s not an either-or choice. Different types of annuity exist, including annuities that never increase, and annuities that increase by a fixed percentage each year. There are annuities that continue to pay out some or all of the income to a spouse after the annuitant’s death. You don’t need to annuitise your whole portfolio, so perhaps a portion makes sense. If you consider it important to leave a legacy, this tends to skew the decision away from annuities.

But if we can get our heads around the simplified all-or-nothing binary choice, this will be a good start.

Enter the Banker

Where am I heading with this? The clue is in the title of this blog! Most of us will have watched the Deal or No Deal TV show at least once. If you remember, the contestant is assigned one sealed box out of several identical ones. Each box contains a sum of money ranging from 1p to £250,000. The contestant tries to beat the Banker by successively opening the other boxes. Every so often, the Banker offers a lump sum of real money to gain possession of the contestant’s box. They can either ‘Deal’ to take the money, or ‘No Deal’ by continuing to play. If they never deal, they get to keep the amount in their box.

You can read more about the TV game on Wikipedia.

The Banker always offers an amount lower than the maximum possible amount in the unopened boxes, but more than the minimum possible amount. This creates a dilemma for the contestant. Is the risk of No Deal worth the potential reward?

Perhaps surprisingly, the Deal or No Deal decision resembles a retiree’s decision whether or not to annuitise. Both decisions involve a trade-off between a lower guaranteed amount and a potentially higher amount with attached risk. The analogy doesn’t stop there. In Deal or No Deal, the risks & potential rewards change each time the contestant opens a box; the Bank will make different offers to be compared with the risks and potential rewards. In retirement, the risks and potential rewards change over time according to changing market conditions and how much the retiree has already spent; annuity rates also change over time.

When should you deal?

Anyone who’s watched Deal or No Deal will realise that deciding if and when to deal is hard. It’s strongly influenced by the contestant’s attitude to risk. Some contestants are willing to risk a large guaranteed sum (say £50,000) for a 50-50 chance of winning £250,000. Others would treat £50,000 as such a good deal that they wouldn’t even consider risking it at those odds even for a lot more.

The annuity dilemma presents a similar type of decision. At the start of retirement, maybe the odds of running out of money by sticking with drawdown are only (say) 5%. So you might need to choose between a guaranteed £3,000 a year and £4,000 a year with 95% safety. In this case, if you’re averagely risk-tolerant, you might well choose £4,000 and drawdown. In effect, you’d be ‘buying’ that extra 5% certainty for £1,000 a year.

Now move the calendar forwards 10 years. Let’s assume investments have performed reasonably well. Let’s say you’re still looking at a safe drawdown rate of £4,000 a year with 95% safety. But now that you’re older you can get a better annuity rate, giving you a guaranteed income of (say) £3,900. Now buying that extra 5% certainty only costs you £100 a year. You’d have to be a real gambler not to choose the annuity.

If you waited even long to annuitise, eventually the available annuity income might be bigger than the safe drawdown income. In this case it’s a no-brainer to annuitise.

Depending on your risk aversion, there’s a cut-off point at which it buying an annuity becomes the rational choice.

Deciding to buy an annuity

According to a recent paper from the National Bureau of Economic Research, most respondents overestimate the probability of rare events, and underestimate the likelihood of more certain, but lower-value, payouts.

As mentioned previously, the real-life decision to annuitise is much more nuanced than our example. By design, EvolveMyRetirement® is able to juggle the many conflicting variables. It may determine for some retirees that immediate annuitisation of a portion of the retirement fund is the most sensible course of action. For other retirees, it may treat annuitisation as an unlikely future possibility. In the case of non-retirees, it’s unlikely to assume early annuitisation, as time may well change things. The bottom line, though, is that annuitisation is always there as a safety backstop, and may be appropriate for some people at some point in time.

Annuity Dilemma: Deal or No Deal

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