Personal Pension  

An annuity isn’t a drag, don’t raid your pot

This article is part of
Pension freedoms teething trouble

Recent figures from the government suggest that more than 60,000 people have transferred more than £1bn out of their pension pots.

This should come as little surprise, because if people are offered cash they will take it. However, as the pent-up demand for cash subsides it is hoped that a significant number of people will return to using their pension pots to generate income.

While many people thought the new pension freedoms would sound the death knell for annuities, the new pension reforms simply mark the beginning of a new era for them. Freedom should not be confused with licence, and just because individuals have the ability to spend their pension pots in any way they like does not mean they should ignore their longer-term income requirements.

Annuities have an important role to play because they meet the needs and objectives of people who want to ensure that they will have a regular income for the rest of their life with the peace of mind and security that they will never run out of income.

Ever since the Israeli economist MenahemYaari wrote about the life-cycle of a consumer with an unknown date of death but with the need to maximise income, annuities have played a central role in economic theory. Mr Yaari showed how a consumer who did not need or want to leave money to the family but wanted to get the maximum utility from their income should annuitise their retirement savings.

Annuities provide the optimum amount of income over the lifetime of the annuitant; not too much and not too little, without any risk to the policyholder.

Academic researchers, mainly in the US, use this term when they try and answer one of the most important questions in retirement income planning.

Why, if annuities provide the optimum income payments for someone who wants to maximise their lifetime income without taking risk and ensures they do not outlive their income, do many people favour higher-risk drawdown options?

The answer to this riddle is twofold. First, many people are reluctant to make irrevocable decisions, and second, there is a reluctance to choose an option that does not pay a lump sum to their beneficaries.

When comparing annuities with drawdown it is important to recognise that annuitants benefit from mortality cross subsidy, which is an invisible force that helps increase the income returns from annuities.

Some annuitants will die before they are expected to and some will live longer than expected, and insurance companies use profits from the early deaths to subsidise the income paid to those who live longer than expected.

Mortality drag is the flip side of the coin. If an annuity purchase is deferred, the annuity payable at a future date will be higher because of the policyholder’s increase in age. However, the absence of any mortality cross subsidy is an invisible force that slows down this rate of increase.