Updated: Oct 26, 2022
Annuities used to be the only means by which most people could create an income from their pension.
Those fortunate enough to have a larger pension fund were afforded greater flexibility and could keep their funds invested whilst drawing down an income over time. But following the legislative changes introduced in 2015, almost everyone now has the freedom to choose how to access their pension. Annuities are now just one of many strategies available. This article presents the pros and cons of buying an annuity.
First, it’s important to understand what an annuity is and how these products work.
An annuity is a financial product sold by insurance companies. You give the insurer all or part of your pension fund, and in return they give you a guaranteed income. The insurer adopts the risk of your life expectancy, investment returns on the premium and, if you purchase an annuity with an escalating payout, they will also own the inflation risk. Products are priced as a percentage of your fund value. So, buying an annuity rated at four percent with a fund of £500,000 would give you an annual income of £20,000.
There are many different options to choose from when buying an annuity. Industry data shows that 90% of all products sold provide a flat income. This is the basis that has therefore been used in weighing up the pros and cons of annuities as a strategy for creating a retirement income.
Pros of Annuities
1. You’re guaranteed not to run out of money.
Keeping your pension fund invested and using drawdown to withdraw cash when needed exposes your fund to market risk. The value of your investments could therefore fall as well as rise over the years. Without good management of the portfolio you invest in and careful consideration of how and when to take withdrawals, the worst case scenario is that you could run out of money.
This would never happen with an annuity, as you are guaranteed the income you’ve “bought”, no matter what happens with investment markets.
If you’re very risk adverse, an annuity might be an attractive option.
2. Your income won’t fall.
Holding the money you’d need to access over the next year as cash (but still within your pension wrapper) protects you from having to sell riskier assets at times when their value has fallen. However, this may not be practical for someone with a small pension fund who needs the returns normally associated with higher risk investments to make ends meet on a monthly basis. They would effectively be forced to maintain a high risk portfolio and risk income shortfall if markets fall.
Even if markets plummet, an annuity will provide you with guaranteed regular income throughout your retirement.
Annuities might be attractive if your only other income is a very small pension.
3. If your life expectancy is reduced you could get much more.
Life expectancy is a key factor in the pricing of annuities. The longer someone lives, the more money the insurer would need to payout. They adjust for this by reducing the amount paid out each year, called the annuity rate.
Conversely, an insurer might pay out more each year to someone whose life expectancy is shorter.
For healthy clients with a normal life expectancy annuity rates are not particularly attractive, however better value can be derived if you smoke, are very overweight or suffer a serious illness.
The cons of buying an annuity
1. Guarantees come at a hefty price.
The flip side of the coin is that the guarantees the insurance company provides come at a price.
Understandably, they will not expose themselves to the risk of making a loss without the opportunity for financial gain. They therefore charge a margin on their expected cost of servicing their contract with the policy holder.
This margin earns a profit for the insurer and means that you and/or your beneficiaries on death are likely to receive less in terms of a total return compared to retaining your pension fund, keeping it invested and drawing down a flexible income over the years.
2. Annuities lock you in.
The Government announced in December 2015 that retirees will soon be able to sell their annuity. However, this freedom will not be implemented until 6 April 2017. Until then there is no opportunity to change your mind – you’re locked into a contract.
Even taking into account this latest this round of pension freedoms, exit fees and low transfer prices may mean that you still need to consider the purchase of an annuity may be an irreversible decision.
3. You are still exposed to inflation risk.
Inflation has remained at historically low levels for some time and many forecasts predict that it will remain well below the Government’s target of 2 percent for some time. It’s important to consider your investment timeframe though. You could live for 20 or 30 years in retirement, taking the same fixed income throughout this period.
If the cost of living increased even at the Government’s target you would see your income fall in real terms by 39.7 percent over a 25 year period, possibly outpacing your inevitable slowdown in spending.
Annuities might not provide the income you need if inflation takes off.
4. There’s nothing to bequeath on death.
Annuity contracts generally come to an end on the death of the policy holder. Even if you died in 10 years’ time there would be no inheritance for your wife or children.
In contrast, any remaining money in a pension fund can be bequeathed to your children without incurring inheritance tax charges. In addition, if you were to die before age 75, any future withdrawals from your fund by your beneficiaries would be exempt from income tax, subject to a £1.25 million upper limit on the size of the pension pot.
There are options to continue payments to your spouse, generally at 50% of your income – but this type of contract still doesn’t provide an inheritance for your children. Some annuity products also pay an income which is guaranteed for a fixed period, ten years for example. Both alternatives come at a price.
5. All your income is taxed.
Once you’ve purchased an annuity you have no opportunity for taking a tax-free lump sum. All your income is taxable.
6. Rates fluctuate.
Moving into or out of the market is a risky business. There’s always a chance that values could shift by 2 percent, 3 percent or even more, up or down the day after you make a transaction.
Annuity rates also fluctuate. There’s a real risk that the rate you get for your annuity could improve dramatically a short time after you bought the contract. That would have a significant impact on your income throughout retirement.
Keeping your funds invested enables you to move funds into cash (to take as income) gradually over time, thereby reducing the risk of getting your market timing wrong. Proactive management of your portfolio via our Portfolio Management Service reduces can also help.
The articles are for information only and should not be construed as advice or a recommendation. The investment strategies mentioned are examples only and may not be suitable for your particular: circumstances, tax position or objectives. Please seek independent financial advice before taking any action.
No advice should be conferred from the articles. No action should be taken without independent professional financial advice as any actions on your pension may be irrevocable and have a big impact on your income in retirement.