Today I’m going to be arguing in defence of the annuity. This venerable financial product is very much on the back foot right now due to sweeping changes to the pensions regime announce in the Budget back in March. But the annuity hasn’t been around for as long as it has without good reason, and I reckon it will be around for many years to come yet, despite what the naysayers are, well, saying. I will be giving my reasons, and then looking at what you need to do when considering whether an annuity is right for you.

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But first…

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Introduction

Usual drill. What you need to know first, followed by what you need to do if you or a loved one is at the point of retirement or maybe even needing long term care.

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Everything you need to KNOW

 

So, let's deal with everything you need to know about Annuities first

 

1 – What is an annuity?

 

Here’s Wikipedia’s definition:

 

A life annuity is a financial contract in the form of an insurance product according to which a seller — typically a financial institution such as a life insurance company — makes a series of future payments to a buyer in exchange for the immediate payment of a lump sum or a series of regular payments prior to the onset of the annuity.

 

 

Or in other words, you hand over a lump sum in exchange for a guaranteed income for life

 

2 – Annuities are traditionally associated with retirement income

 

Personal pensions, and now most company schemes are now about saving up to accumulate a fund of money. This fund has for centuries been used to buy an annuity, a guaranteed income, calculated using mortality tables. The determinant factors: age, gender, health (enhanced annuities) – how long will you live?

 

Different shapes are available:

 

• • Level, rising with inflation

 

• Life or fixed term

 

 

• Investment backed (unit-linked or with profits)

 

 

 

3 – Why the annuity is (supposedly) under threat

 

Life expectancy is increasing, making annuities more expensive. Returns from investment are lower, making it more difficult for LifeCo’s to make a profit – they invest your money for their own ends, and to secure the income they have promised you.

 

Time was, you had to buy an annuity; it was the only choice. Then Income Drawdown came along as an alternative. And then came Budget 2014:

 

• • Unlimited access to pension funds, dip in and out

 

• With this kind of flexibility, who needs the restriction of annuities?

 

 

• Share price of annuity providers

 

 

 

4 – Why I think the annuity will be around for a long time yet

 

Annuities are all about guarantees. Who is taking the risk that you money will run out? That you will live longer than your money will?

 

Three risks:

 

1) Inflation will erode your purchasing power over time – need to make sure you have enough

 

2) Underestimating life expectancy – MGM Advantage study shows 79% of males and 85% of females approaching retirement underestimated how long they were going to live, and missing the true average life expectancy figures by five years for men and ten years for women

 

3) Tail-risk of longevity: Life expectancy tables are just averages. Problem with averages is half of all people will live longer than the average

 

Aside: most people talk of the risk of not living long enough to get your money back. Much more likely that you’ll live too long

 

Annuities transfer these risk onto the issuer of the annuity, usually a LifeCo.

 

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Everything you need to DO

So let's deal with everything you need to DO if you are at the point of retiring, or if you are otherwise considering an annuity

1 – Establish all non-annuity sources of income

State Pensions, Final Salary company schemes, rental income. Is this enough? If not, how will you fund the difference? Pension funds or other capital?   Throwback to last week here – Session 83, how much is enough?

2 – Determine likelihood that you will outlast your money?

This is an inexact science with many variables:

• Size of difference between your income and outgoings
• How likely you are to spend lump sums?
• Longevity (see above for underestimation risk)
• INFLATION!

Remember you will almost always spend more in your retirement than you think because:

• More leisure time
• Higher proportion of total outgoings is food and fuel
• You’re used to earnings rising higher than the rate of inflation

3 – Determine your tolerance for risk and capacity for loss

An adviser can help with this, but try to imagine scenarios:

• If you opt for drawdown, how much can you afford to lose if markets are against you?
• Can you live on just your guaranteed income from the state or company schemes if your lump sums run dry?
• Are you likely to lose sleep worrying about money?

Only an annuity can guarantee a given level of income for life

4 – Remember an annuity doesn’t have to be all or nothing

Part drawdown/part annuity approach   Fixed term annuities   Guaranteed drawdown (be careful of costs here)

Summary

All the reasons why annuities were invented (guaranteed income for life, in the shape you choose) have not gone away, despite the pressures of reduced annuity rates, alternatives such as drawdown, and new budget flexibility.   The changes announced in the budget might lead to a flurry of unwise encashments. Hopefully advisers will present the right options to those who seek advice, but plenty won’t seek advice at all.   Then things will settle down, and people will realise the key benefit of annuities – a guaranteed income for life – and if that is right for them, will continue to buy annuities by the bucketload.

This week’s reviews

None this week – for shame!   If you like what you hear on this podcast, please leave a rating or review on iTunes by hitting the button below. This helps others to hear about the show and to subscribe, because it keeps me near the top of the rankings.  

News

Weight loss: Static – grrrrr!

Next Session Announcement

Next time I’ll be chatting to a friend of mine called Tina Weeks. Tina is a financial planner in North London and is at the forefront of the financial life planning movement in the UK. Life planning is less about the money than it is about the person who the money belongs to. So I’ll be asking Tina about her methods and about what she thinks is important about money. If you have a question on this subject, or any other financial query that you want answering here on the show, then the best way to do that is to leave me a voicemail at meaningfulmoney.tv/askpete

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Outro

That's it for this session of the MM podcast, I hope it was helpful. If you have any questions or comments, please leave them comments section below. I hope you enjoyed this session. Thanks for listening – I'll talk to you next time.