The point in retirement when switching to an annuity yields a better outcome

The point in retirement when switching to an annuity yields a better outcome

There could be an optimum point during a person’s retirement when switching to an annuity will give them better outcomes, according to LCP.

Research from the consultancy, published last week (November 27), found pensioners should revisit the decision to use drawdown in later life and consider switching some or all of their savings into an annuity.

The paper 'Is there a right time to buy annuity' is based on a model which compares the happiness a retiree would get at each point in their retirement from staying in drawdown compared with switching to an annuity.

The model looked at potential outcomes over a range of more than 2,000 different scenarios for future investment performance and life expectancy.

It took into account factors such as attitude to risk, allowing for the fact that people generally have ‘loss aversion’ and feel more dissatisfaction from losing money than happiness from gaining it, and a desire to have funds at the end to pass on as inheritance.

According to the model, someone aged 60 who chooses drawdown is likely to be 10 per cent happier overall than someone who uses all of their pension pot to buy an annuity.

However, as a person gets older, annuities become more attractive and at around age 67, the model shows that the retiree would be happier overall with an annuity.

Steve Webb, partner at LCP and co-author of the report, said: “Whilst forcing people into annuities in their late fifties and sixties was not the right approach, it would be wrong to write-off annuities altogether.  

“This powerful research shows that for a wide range of people there could come a point during retirement when a switch to an annuity gives them better outcomes overall. Policy makers need to think how best to nudge people to review their finances not just at retirement but during retirement.”

LCP found in all the models it tested there was a crossover point where annuities became more attractive to people, but the age at which this happened could vary depending on different factors.

For example, if an individual is willing to take higher investment risk in their drawdown portfolio, the age at which an annuity becomes more attractive rises.

For a 75 per cent equity portfolio, switching to an annuity makes sense at age 70, compared with age 67 for a 55 per cent equity portfolio.

Also, a ‘hybrid’ approach where the individual uses part of their pot to annuitise at 60 and then buys another annuity with the rest of the pot later in retirement creates the best outcomes at all ages, according to the model. 

In this case the ‘crossover’ point where the balance of the pot is annuitised would be around age 71.

Annuities become more attractive as people get older because individuals gradually find it more difficult to ensure their pot does not run out of money.

LCP suggested mid-retirement MOTs could be introduced to deal with this issue.