PensionsJan 21 2015

Annuities redux

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When George Osborne announced his radical shake-up of pensions many people thought this sounded the death knell for annuities. But, while sales of annuities have already significantly fallen, they are by no means facing the end.

Rather than signalling the end of the road for a policy that has been around since Roman times, the new pension reforms mark the beginning of a new era as advisers and their clients recognise that annuities are still the only policy that can guarantee an income for life, and insurance companies are busy innovating to produce annuity policies that take advantage of the new flexibilities.

The case for annuities

Being the only policy that can pay out for life, an annuity is a kind of pension, and in the rush to give people more flexibility at retirement, it is easy to lose sight of why people save for a pension in the first place.

The case against annuities

Annuities are not without their critics. The three most cited criticisms are:

■ Annuities pay a low rate of income and are poor value for money

■ The income stops when the policyholder dies

■ There are better ways to convert a pension pot into income, for example, drawdown or fixed income plans

On the contrary, a significant amount of academic research has shown that annuities are actually good value. For instance, the Financial Conduct Authority’s paper of December 2014 titled ‘The value for money of annuities and other retirement income strategies in the UK’ concluded that annuities purchased on the open market provide reasonably good value for money because consumers get the vast majority of their premiums returned to them in income.

The only alternative to an annuity is a form of drawdown. There are a number of different types of drawdown, such as the new uncrystallised funds pension lump sum from April 2015 and fixed-term income plans.

All drawdown policies (except unit-linked guarantees) have one thing in common: they do not have an income for life guarantee. This means that it is possible to run out of income at some time in the future if investment returns are lower than expected or the investor lives longer than expected.

In practice this means at first sight drawdown may appear more attractive than an annuity, but when advisers and their clients understand the risks, are annuities such a bad way to convert capital into income?

I believe there is a strong case for annuities, and they will continue to play an important role in retirement income planning in the future. Although everybody will be free to take their pension as a cash lump or regular income payments, the advantages of securing an income should not be ignored.

Looking to the future, I predict four important trends, as follows.

1. Small pots being taken as cash

In the US they talk about the utility value of money. I take that to mean that someone may get more benefit from a cash sum of say £10,000 rather than getting £ 42 a month from an annuity. For this reason it is understandable why many choose to take small pensions as cash. However, there will be a cut-off point at which it may be better to use a pension fund to provide income rather than cash, depending on an individual’s tax position. This does mean that there will remain a particularly strong case for annuities for those whose pots are too big to take as cash because of the tax, but bigger enough to get the full benefits from drawdown.

2. New product developments

As part of its pension reform programme, the government will change the rules for annuity policies so that insurance companies can develop new options and design new features.

Essentially product providers will be able to innovate in three areas: the length of the guarantee period, the value protection option and the option for income to change in response to changes in personal circumstances.

Currently the maximum guarantee period is 10 years, but this may be extended to 20 or even 30 years, which will help those who are concerned that when they die the annuity income will stop.

In the future insurance companies will able to design annuities in which the income payments may increase or decrease in specific circumstances. This will obviously affect the starting income but will provide valuable peace of mind for those who want their future income to meet their needs.

3. More sophisticated use of annuities in retirement income planning

In the past, advisers and their clients often thought of an annuity purchase as a black or white decision. Generally speaking the smaller funds purchased an annuity and the larger funds invested in drawdown.

This rather simplistic approach to retirement income planning will probably be replaced by a more considered approach to annuities based on income requirement and the need for guarantees. For instance, the income that is essential should be guaranteed; the income for desirable expenditure such as holidays should not be put at risk; but non-essential income can be taken from more risky investments. This is sometimes called the ‘income pyramid’ approach.

An even more sophisticated approach is to consider a form of phased retirement, sometimes called ‘salami slicing’, whereby the pension fund starts off in a drawdown plan, and each year part of the fund is used to purchase an annuity. Not only does this mean that each year a larger part of the overall income is guaranteed, it also helps overcome the negative effects of mortality drag.

4. Increase in the personal underwriting of annuities

One of the most important changes I have seen in the annuity market over the last 20 years has been the increased use of advanced underwriting techniques for enhanced annuities.

In one sense most annuities are now underwritten because most companies price their annuities based on the postcode of the annuitant.

At first sight it may seem that now everybody will have the freedom to take their pension in any way they wish –those with smaller funds will take their pension as cash and those with larger funds will invest in drawdown.

But on reflection, many of those who may be attracted to taking their pension fund as a cash lump sum may change their minds when they realise that any lump sums will be taxed at their marginal rate of tax. Those considering drawdown may also change their minds when they understand the risks they will be taking in an uncertain environment.

Billy Burrows is director of Retirement Intelligence and associate director at Key Retirement

Key points

■ Annuities are the only policy that can pay a relatively high level of guaranteed income for life.

■ At first sight drawdown may appear more attractive than an annuity, but when risks are taken into account, that may not be the case

■ One approach is to consider a form of phased retirement whereby the pension fund starts off in a drawdown plan and each year part of the fund is used to purchase an annuity.