Advisers should not ignore annuities

A 65-year-old can buy an annuity now that will provide a yearly income for life of more than £7,000 per £100,000 of pensions savings. And that old chestnut about lack of death benefits? Well, this annuity comes with a 10-year guarantee.

If that is not enough, higher guarantee periods are available as well as full value protection – a money-back guarantee less payments to the date of death. Higher death benefits will impact the income payable, but even selecting 100 per cent value protection still provides more than £6,500 annual income. 

These figures do not take account of inflation, but an annuity escalating at 3 per cent currently pays more than £5,000 a year. That is not all. These figures are based on a healthy life. Anyone with medical conditions or a lifestyle that may shorten their life expectancy could expect a higher income. 

Let’s explore the alternatives. According to the latest analysis by Morningstar, around 3 per cent is a safe withdrawal rate to provide a 95 per cent probability of success. Increase this to 4 per cent withdrawal and the probability of success falls to 80 per cent.

Firstly, it is not a binary decision. People can choose drawdown and also use part of their fund to buy an annuity.

Consider the practical implications of this. A 65-year-old, retiring with a £600,000 fund, might feel relatively well heeled, but if they limit withdrawals to 3 per cent this would provide an income of £18,000.

Even with a full state pension of £9,628, this would still fall significantly short of the £38,860 (gross) required for a ‘comfortable’ retirement as defined by the Pension and Lifetime Association’s retirement living standards. 

In contrast, our 65-year-old with a full state pension could exceed the requirements for a ‘comfortable’ retirement by buying an annuity, including escalation at 3 per cent, without fear of running out of money. 

Some people might be concerned about lack of flexibility to vary income or take ad hoc amounts. They might want to leave the maximum they can on death and believe drawdown is the way to achieve this.

Let’s examine this more closely. Firstly, it is not a binary decision. People can choose drawdown and also use part of their fund to buy an annuity. There is a growing body of evidence from leading actuarial organisations that this often produces a better outcome.

People who have annuitised are less likely to suffer from depression or feel sad compared with those who choose drawdown.

A report by global actuarial consultancy, Milliman, concludes that often death benefits, and a higher level of sustainable income over the long term, can be higher in an equities/annuity portfolio than an equity/bond portfolio. 

Consider a 65-year-old with a £500,000 fund planning to withdraw 4 per cent to provide £20,000 income. If they buy a single life level annuity for £200,000 this would currently provide over £14,000. That means they only have to withdraw less than 2 per cent from the remaining drawdown fund, which can remain 100 per cent invested in equities/alternative assets.

As most of the income is provided by the annuity, the impact of sequencing risk is modest and the fund should grow more rapidly over the long term than a traditional (60/40) equity/bond portfolio.  

There is another issue to consider. Bonds are traditionally considered to be negatively correlated with equities, but this inverse relationship has recently been questioned. There have been several occasions when both equities and bonds have fallen in value at the same time, including the most recent market falls.

Not only is the income from an annuity guaranteed not to fall, it is payable for life.

The assurance that comes from knowing there is a regular guaranteed monthly income lies at the very heart of Maslow’s hierarchy of needs.

It’s very easy to focus on the hard numbers, but there is a valuable emotional benefit from buying an annuity: peace of mind. Many people would prefer to focus on enjoying their retirement, rather than worry about their investments.

A 2018 study found that people who have annuitised are less likely to suffer from depression or feel sad compared with those who choose drawdown.

The assurance that comes from knowing there is a regular guaranteed monthly income, payable for life and immune from the vagaries of investment markets, lies at the very heart of Maslow’s hierarchy of needs. The primal urge to feel safe and secure, to have enough food, drink, shelter, clothing, and warmth.

Advisers should not ask themselves whether an annuity might play a part in a retirement portfolio. They should ask the question: why would a solution that provides a guaranteed income for life not lie at the heart of my clients’ retirement strategies? 

Stephen Lowe is a director at Hub Group