Can annuities make a comeback?

Research from the Financial Conduct Authority would suggest the main reason consumers use drawdown products is to access their tax-free cash.

Could it be that consumers are using drawdown products as a temporary stop-gap between accessing tax-free cash and making long-term retirement plans? If so, what does this mean for the future of annuities?

The main reason people choose to purchase drawdown contracts is to access their tax-free cash

Since the implementation of pension freedoms in 2015, drawdown products have displaced annuities as the UK’s most popular retirement income product, outselling annuities by nearly three to one. However, despite the boom in sales, drawdown products might not be as popular with consumers as first appears.

While the benefits of drawdown products over annuities are considered to be their flexibility and potential for higher returns and legacies, many consumers may not have really considered these factors, or indeed retirement planning at all when entering into drawdown.

Accessing tax-free cash

In fact, it transpires that the main reason people choose to purchase drawdown contracts is to access their tax-free cash.

The FCA’s Retirement Outcomes Review shows that for consumers of all wealth brackets, overwhelmingly the most popular reason for moving their pension funds into drawdown products was to access the tax-free lump sum.

Some 56 per cent of customers with pension funds of more than £100,000 stated accessing a tax-free lump sum as a reason for moving to drawdown, while flexibility was a reason given by less than 7 per cent of consumers. 

It seems that the majority of consumers may not be primarily motivated by long-term retirement planning when initially choosing to move their pension pots.

Instead, a drawdown product appears to be the ‘path of least resistance’ when choosing to access their tax-free cash. Effectively, consumers are choosing a product with the main aim of taking as much out of it as possible.

The FCA also asked consumers if they knew how their drawdown product was invested. Almost 30 per cent of people were not sure how their retirement savings were invested, and a further third of people only had a broad idea. 

This further adds to the idea that many consumers may only be thinking about the short term when making decisions relating to their pension funds, focusing on the 25 per cent of their pension fund that they can immediately access and not seriously considering how the remaining 75 per cent should best be used.

In order to counteract the long-term implications of customers making decisions based on accessing a small proportion of their pension pot, the regulator is encouraging the government to consider allowing consumers to access their tax-free cash without transferring all of the pension fund out of their existing accumulating product.

The FCA states that this will “let consumers put off deciding what to do with the rest of their pot until they are ready to focus on it.”

The benefit of this proposal would be that consumers would remain invested in a more suitable investment strategy for longer. However, this would represent a significant upheaval in the way that pensions are taxed; for example, the lifetime allowance assessment is currently made at the point when the tax-free cash is taken. 

The fact that customers are not fully engaging with retirement decisions when choosing drawdown products, could be good news for annuities.

If the current level of drawdown sales do not necessarily represent a widespread consumer preference for the product, then drawdown might not remain the most popular retirement product in the long term. 

Safe withdrawal rate

Recent reports suggest that when it comes to drawing a sustainable income, drawdown products might not offer the level of income that many expect.

The 4 per cent ‘Bengen’ rule is traditionally quoted as a safe withdrawal rate, whereby retirees take 4 per cent of their initial pot as income each year adjusted for inflation. But this rule was published in 1994 based on US investment returns.

Recent research by Morningstar suggests that in the UK, retirees should be using “lower initial safe withdrawal rates…2.5 or 3 per cent and not the previous 4 per cent”.

Currently, annuities with inflation protection offer more than 3 per cent a year.

If, when it comes to planning a sustainable source of retirement income, drawdowns are not offering high income levels, might annuities make a comeback? Hargreaves Lansdown published a report in December 2017 that stated annuity sales could double by the mid-2020s. 

While only 12 per cent of people currently buy an annuity, the survey of 1,001 55 to 65-year-olds found that 43 per cent of people approaching retirement envisage buying an annuity.

At the time the research was published, Nathan Long, a senior pension analyst at Hargreaves Lansdown, stated that the pick-up in demand for annuities “is more a matter of when rather than if.” 

There is much evidence from consumer research that individuals’ biggest fear in retirement is running out of money. In addition, most people are typically risk averse and there is evidence that this risk aversion can increase by a factor of five in retirement.

Therefore, consumers in retirement are more likely to place a high value on a guarantee, which would suggest that an annuity could be an ideal fit.

There have also been many recent studies that have highlighted the financial advantages of considering annuities as part of retirement planning. Research published earlier this year by the International Longevity Centre demonstrates that while “annuity bashing” has become “something of a national sport”, annuities do actually offer consumers fair value for money given the longevity protection they provide. 

Key Points

• People are using drawdown mainly for the tax free cash
• Few realise the dangers of drawdown
• Annuities still offer a guarantee, which appeals to many in retirement

In addition, actuarial consultancy Milliman published research last year which demonstrated that the benefit of purchasing an annuity extended beyond just guaranteeing an income for life.

The Milliman white paper, Annuities Reinvented, showed that combining annuities with drawdown could not only increase income sustainability, but could also lead to larger death benefits, particularly for clients that live longer . 

While that research was based on a customer having a separate annuity and drawdown product, recent developments suggest it may be possible to achieve a similar strategy on a platform.

Just and Novia Financial have recently launched a guaranteed income proposition that can be accessed within a self-invested personal pension. This would allow advisers to implement a flexible investment strategy with a guaranteed income within one platform.

Colette Dunn is head of strategy consulting and Marie-Lise Tassoni is a consulting actuary at Milliman