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

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.

The practical relevance of mortality drag is that a pension drawdown fund has to increase in value by an additional amount to compensate for the lack of mortality cross subsidy if it is to maintain its ability to buy an annuity paying the same income in the future.

Annuities are based on the principle of mortality cross subsidy, and while this is good for those in good health and stand a good chance of beating the bet with the actuaries, they are not such a good bet for those in poor health. To solve this problem, insurance companies offer enhanced annuities which pay out a higher income for those in poor health.

Those who smoke, take prescription medication or have been in hospital recently may be able to qualify for an enhanced annuity.

I believe there is a strong case for annuities and that they will continue to play an important role in retirement income planning. Although everybody will be free to take their pension as a cash lump sum or regular income payments, many people will recognise the advantages of securing a guaranteed income and use some or all of their pension pot to purchase an annuity.

Looking to the future, I predict three important trends:

1 New product developments and annuity buyback;

2 More sophisticated use of annuities in retirement income planning;

3 Better understanding of the behavioural aspects of decision-making.

Insurance companies can now increase the length of the guarantee period on annuities.The maximum guarantee period in the past was 10 years but will be extended by some insurance companies to 20, or even 30 years. This, together with more favourable taxation of the value protection benefit will help those who are concerned about dying and leaving their dependants short of income.

There is now an interest in deferred annuities. For example, someone could purchase an annuity at, say, 60 which would not come into payment until he reached the age of 85. At first this might seem like dead money, but if his 85th birthday was reached the income would be guaranteed for the rest of his life. This could be a very useful addition to a drawdown plan because it would provide insurance against running out of income in later life.

The final piece of the annuity jigsaw came in the March 2015 Budget when details were announced of plans to allow people to convert existing annuities in payment into a cash sum. The proposal is to allow people to assign the income from an annuity to a third party who will pay a cash sum either directly to the policyholder or into another pension plan. Tax will be paid at the recipient’s marginal rate when cash is paid out. The intention is that the so-called annuity buyback option will be available after April 2016, and this means that those who purchased an annuity in the past will be able to take advantage of the new pension freedoms.

In the past, many advisers and their clients thought of an annuity purchase as a black or white decision; smaller funds purchased an annuity and the larger funds invested in drawdown. This rather simplistic approach to retirement income planning should be replaced by a more sophisticated approach to annuities based on customer needs and wants.

Generally speaking there are three important things everybody should consider when they reach retirement age:

• How much income is required now and in the future?

• How much flexibility will be needed?

• How much risk should sensibly be taken?

Most people need income, but while it is tempting to have the pension pot paid as a cash sum, this may not be the best answer for those who do not have a genuine need for cash – for example, to pay off debt or to fund a luxury such as a new car or a world cruise. Not only is there a risk of paying too much tax, but taking a pension in cash means giving up the option to have a regular income each month.

Flexibility and certainty are opposite sides of the coin. For most people, flexibility is desirable but certainty is more important. There are very good reasons why people may want flexibility – income needs may change, circumstances can alter and health may deteriorate. But this flexibility comes with the price of less certainty.

One of the best ways to maintain flexibility while having an income is to invest in a drawdown plan. However as this strategy may be too risky for many, it may make sense to split a pension pot between annuities and drawdown in order to have some flexibility and some certainty.

As neither annuities nor drawdown on their own deals with all these risks, a good way to reduce risk in retirement is to invest in a combination of annuities and drawdown.

In conclusion, annuities will have an important role to play in the future. Although sales of annuities may be lower, especially for younger pensioners in good health, they will be used in a more sophisticated way. For instance, people are being advised to secure the amount of retirement income they need for their basic everyday needs through the purchase of a guaranteed annuity, and in order to avoid the negative effects of mortality drag, it often makes sense to purchase annuities at regular intervals in older age. Also, the benefits of enhanced annuities must not be overlooked because they are still one of the best ways for those in poor health to boost their income.

Finally, the buzzword at the moment is ‘blended solutions’, and guaranteed annuities are the basic component in most combinations of retirement income solutions.

Billy Burrows is director of Retirement Intelligence

Key points

When 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.

For most people, flexibility is desirable but certainty – gained from having an annuity – is more important.

Sophisticated new product developments and annuity buyback will come to the fore, as will blended solutions.