Pensions  

How to solve the ‘risk paradox’

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    The paper advanced the argument that because guaranteed annuities are so low and for many they represent little more than the return of the original capital, those with above-average-sized pension funds should question whether the traditional annuity should continue to be their default option. I also pointed out a number of paradoxes in the annuity market, not least that most people make decisions about their long-term income based on short-term factors such as starting income.

    In the longer term all pensioners are faced with a number of unknowns: they do not know how long they will live, what will happen to inflation, interest rates and equity markets, or how healthy they will be. The point is, a guaranteed annuity might meet a pensioner’s needs today, but it is not flexible and cannot be altered if circumstances change.

    The annuity risk paradox suggests that many people think they are eliminating risk with a traditional level annuity, but in reality they are still exposed to a number of risks.

    My conclusion is that those with above-average pension funds should consider investment-linked annuities or drawdown, but this begs the question – what can those with below-average pension funds do if they think guaranteed annuities are poor value?

    All pensioners are equal but some have more choice than others due to the size of their pension pots. Therefore it is necessary to look at the options for those with different-sized pension pots, assuming the average pension fund at retirement is valued at only £30,000.

    The options for those with below-average-sized pension pots are limited.

    Although this group accounts for the largest number of private pension policyholders, they have the least realistic choice and arguably get the worst deals.

    Table 1 shows the options for those with below-average pension funds who have reached retirement age.

    AdvantageDisadvantageComment
    Take tax-free cash and purchase an annuity nowSecures income now and avoids the risk of getting an even lower income in the futureRates are at an all-time low and may increase in the future but probably not for several years if at allUnless there are special circumstancestaking a pension now may be the best option for those with small funds
    Defer taking TFC and annuity purchasePossibility of higher TFC and annuity in future You will only benefit from this if both the value of pension fund and annuity rates increaseIn the past, those who have deferred purchasing annuities have rarely been better off
    Take TFC now and purchase an annuity laterReleases cash sum now ans defers decision on annuity purchaseRates may not improve and there will be costs involved with this option as it involves pesnion drawdownPension drawdown is not usually recommended for those with small funds unless there are special circumstances
    Invest in a flexible annuityPotential for income growth and option to convert to guaranteed annuity in the futureThe level of future income may be more or less depending on investment growthAny annuity that is not guaranteed is risky and should only be considered if the three goldern rules are noted

    Golden rules

    Generally speaking, any annuity other than a traditional annuity should not be arranged and, in addition to the established rules governing advice, I have developed three additional rules:

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    Please answer the six multiple choice questions below in order to bank your CPD. Multiple attempts are available until all questions are correctly answered.

    1. A guaranteed annuity might meet pensioners needs today but it is not flexible and cannot be changed in future circumstances change

    2. How big is the average sized pension pot?

    3. Which is an option not considered by the author?

    4. Having another source of income or capital is important

    5. Alternatives to guaranteed annuities are not viable unless the pension fund is over how much?

    6. What is the main danger of a guaranteed annuity?

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