Buying a lifetime annuity is a decision you shouldn’t take lightly. In return for a guaranteed income for life you’d be sacrificing a chunk of capital. On the other hand guaranteed income can do wonders for our peace of mind. In retirement the alternative to annuities is drawing down our pension and/or other investments. This could work out better, but if investments perform badly you could risk running out of funds. When pension freedoms were introduced, most people found the decision a no-brainer. Annuity rates were pitiful, and so drawdown usually made eminent sense. Now that rates have significantly improved, the decision should be more nuanced.
Factors in making a decision
It’s not as simple as making a one-off decision. Even if you decide that now is not a good time to buy an annuity, that may change in the future. As you get older, the rates on offer become more and more attractive. For example, at the time of writing, a level single-life annuity rate for a 65-year-old is around 6.5%. But this goes up to 8.5% for an 75-year-old, and 13.3% for a 85-year-old. And it keeps going up as you get older. Leaving aside for the moment any desire to leave a legacy, it’s logical that there should come a point in your life where the return on an annuity exceeds the safe drawdown rate.
The desire to leave a legacy may be a factor in avoiding annuities, irrespective of available rates. But buying annuities is not necessarily an all-or-nothing decision. There may well be a optimal level of guaranteed income that simultaneously reduces retirement risk and increases the likely legacy. This is because a high risk of running out of money also reduces the likely legacy.
So our decision-making process should cover both when to buy an annuity and how much to annuitise. In addition, we need to decide whether we want the guaranteed income to remain level or to rise each year; with the latter the rates are lower. And for a couple, it’s important to consider whether you should transfer some or all of the income to your partner should you die first.
How to use EvolveMyRetirement® to create an annuity strategy
All these factors push in different directions. The desire to leave a legacy pushes towards minimising the amount we annuitise, and deferring it as long as possible. Our risk aversion pushes towards maximising it, and doing it sooner rather than later. Our desire for higher discretionary spending could push either way, depending on prevailing annuity rates. And the best type of annuity depends on numerous factors, such as whether we have a partner and expected inflation.
The EvolveMyRetirement® retirement planning tool allows you to completely disable the possibility of creating new annuities. But doing this may close the door to finding the strategy that best suits your real needs. Assuming you haven’t disabled annuitisation, there are five relevant settings you can modify. But finding the optimal combination of settings is really a superhuman task. So our built-in optimisation has a much greater chance of doing so. Sometimes more than one optimisation can lead to further improvements. The program is regularly updated with current market annuity rates, with any gaps filled via standard interpolation methods.
Understanding the annuity strategy
There are three broad types of annuitisation strategy, any of which might result from running an optimisation:
- Possibly buy an annuity now (year 1) subject to certain conditions being met.
- Possibly buy an annuity in the future (year 2 onwards) subject to certain conditions being met.
- Never buy an annuity under any circumstances.
Once you have an annuity strategy that gives good projected results and it’s one of the strategies 2 or 3 above, then there’s no immediate action required. But if it’s strategy 1, then action may be indicated if specific conditions are met. The Explanation report on the Results page will give you guidance on how to make that decision. Under the “Actions You Can Take Now” section it will say something like the following:
“Can you reach a total guaranteed income equivalent to [25%] of your current total spending by buying new [level] annuities? To achieve this, these additional annuities would need to generate a starting income of [£10,000] by investing up to [£90,000], following the member allocation guidelines in your strategy. Only buy new annuities if you can achieve this or if regulations force you to.”
The highlighted items are just examples, including the choice of level annuities (as opposed to index-linked or fixed-increase).
Checking the strategy
EvolveMyRetirement® has features available to Premium users that enables you to check your strategy. The first check is to run sensitivity analyses on each of the relevant strategy settings. This should indicate how close to optimal the current strategy is.
Once you’re satisfied with your strategy, then if it indicates immediate action you should check available annuity rates, based on your specific circumstances. We recommend using the MoneyHelper comparison tool for this. In the example above you’d look for the level annuity income on £90,000, which you’d be expecting to generate an annual income of around £10,000.
You can then simulate implementing it by making a copy of your plan. In the copy, you should reduce your pension holdings by £90,000, first using up any already in drawdown. You should then create an annuity (guaranteed income) based on the amount obtained from MoneyHelper. In the example it would be a level annuity. Since you’ve now implemented the strategy for annuitisation in year 1, you should update the earliest annuitisation year to 2 or more. You can then check the Results page to see how things look.
If you don’t have enough pension funds to buy the annuities, you need to make up the difference with other investments, leaving ISAs till last. These funds would then buy a separate purchased life annuity. You’d need to calculate or estimate the annual tax-free allowance. The tax calculation depends on the type of annuity, and you may need professional advice. However you can estimate it based on the HMRC website.
Buying an annuity
Finally, once you’re satisfied with your annuitisation strategy, and you’ve decided you wish to buy an annuity, we strongly recommend using an independent financial adviser. They’ll charge you a fee, but they should have access to a broader choice of annuities than if you directly approach a provider. For such an important and irreversible financial decision, professional advice is worth paying for. The adviser may well repeat many of the planning steps that you already completed using EvolveMyRetirement®. Possibly they’ll use a different in-house planning tool. They need to get a holistic financial picture before they can provide regulated financial advice. This is a good thing.
We believe you’ll obtain the best and most cost-effective results if you first use EvolveMyRetirement® to arrive at a proposed annuity purchase (if any); and then have a financial adviser validate it and implement it, possibly with improvements.