You work. You retire. You buy an annuity. You receive a guaranteed income for life.
Or so it once was.
A brief history lesson:
- Before 1995, annuity purchase was, broadly speaking, the only way to draw on pension savings,
- The introduction of drawdown offered much more flexibility. Up until 2015, so-called ‘capped drawdown’ was the most common version of this, prescribing strict limits on the amount of income you could take, typically up to 150% of the income that a heathy person of the same age could get via annuity purchase,
- Flexible drawdown was added to the mix in 2011. This removed the cap on income but was only available to those with other sources of guaranteed income,
- ‘Pension Freedoms’ in 2015 introduced ‘flexi-access drawdown’, which effectively removed the stabilisers, enabling you to take as much or as little from your pension as you wish.
Flexi-access drawdown (FADD) is now by far the most common way in which retirees draw on their pension savings – around 8 in 10 people according to recent FCA data. We’ll be covering the mechanics of drawdown, along with the ‘pros & cons’, in an upcoming blog.
Meanwhile, annuity purchase has been ‘left out in the cold ’for much of the past decade, albeit it is enjoying something of a renaissance more recently.
The question we pose in this week’s blog is whether more people should be considering annuity purchase in retirement?
How do annuities work?
Annuities provide a guaranteed income for life.
The mechanics are best explained by way of an example:
Jack is 65 years old, and recently retired.
- He has amassed pension savings of £600,000,
- He is extremely risk averse and seeks the security of a guaranteed income; he therefore wishes to purchase an annuity,
- He is a non-smoker and has no known health issues,
- He opts for a level annuity (i.e. one that pays the same nominal income level throughout).And he purchases this on a single life basis, with a ten-year guarantee (if he dies within the first ten years, the contract will continue to pay the full income amount to a named beneficiary until the end of that period),
- He opts to draw his maximum 25% tax-free cash entitlement - £150,000 shall be paid out to him, with the remaining £450,000being used to buy an annuity,
- On current rates, Jack can attain an income of c. £30,000a year / £2,500 a month, equivalent to a rate of 6.7%,
This will be subject to income tax at Jack’s marginal rate.
The 'pros & cons'
On the plus side…
- Guaranteed income: Annuities provide a guaranteed income for life. In contrast, with drawdown, there is a risk of outliving your savings,
- Smooth transition to retirement: As noted earlier, the ‘salary-like’ features of annuities (you receive a monthly income with tax deducted via PAYE) enable a smooth transition to retirement. In a previous blog (Retirement: preparing for the third act), we discussed the emotional challenges of moving from a period of ‘accumulation’ to one of decumulation, i.e. drawing on your amassed savings,
- Optionality: Whilst annuities are certainly less flexible than drawdown (see below), there is at least some optionality at outset. For example, whether you opt for a level or escalating income; single or joint life; and a guarantee period. That is, you can tailor the annuity to suit your needs at least to some extent,
- Enhanced rates: Annuity purchase is subject to underwriting. Younger and healthier people shall receive a lower starting income, as they’re likely to live longer. Whereas those with health issues and a shortened life expectancy may have access to enhanced rates.
However…
- Inflexibility: Annuities are much less flexible than drawdown where retirees can keep their pension invested, providing scope for additional investment growth, and draw as much or as little from their savings as they wish,
- Low interest rates: Up until recently, annuity rates have been very low as these are tied to bond yields. Meanwhile stock markets have performed strongly, to the benefit of those favouring drawdown (where the monies stay invested),
- Poor death benefits: Perhaps most significantly, annuities offer inferior death benefits as any income dies with the annuitant (or their surviving spouse/partner in the case of a joint life annuity). In contrast, any unused drawdown funds shall be passed down to the chosen beneficiary, and free of inheritance tax!
- Underwriting: The required health checks are intrusive and can cause delays at outset. Albeit I’d argue that this offers a ‘free health check’ which is no bad thing.
Disclaimer: A pension is a long-term investment and funds are not normally accessible until 55 (rising to 57 from April 2028). When investing via a pension, your capital is at risk. The fund value may fluctuate and can go down, which would have an impact on the level of pension benefits available. Your pension income could also be affected by the interest rates at the time you take your benefits. The tax implications of pension withdrawals will be based on your individual circumstances, tax legislation and regulation which are subject to change in the future.
Time for a rethink?
Over the last two years, interest rates have risen significantly. In turn, this has pushed up annuity rates to much more attractive levels than previously.
This has prompted a resurgence in demand, with a 39% increase in annuity sales over the twelve months to end-June 2024.
They’re not for everyone – drawdown still offers superior flexibility and death benefits; however, they shouldn’t be flatly dismissed either. They have a place, particularly for those that are risk averse or where leaving a legacy is not a high priority objective.
An annuity-drawdown blend
It’s also important to note that it isn’t ‘all or nothing’. That is, annuity purchase and drawdown are not mutually exclusive – you could do a blend of the two.
In fact, a strategy I like, subject to affordability, is to secure sufficient guaranteed income to meet at least your essential spending needs in retirement, whilst opting for drawdown on the balance to fund more discretionary spending goals – the ‘bucket list stuff’.
Expanding on the previous example:
- Jack estimates his essential spending needs at around £24,000 a year – this is the minimum amount to maintain at least a reasonable standard of living. On top of this, he anticipates spending around £3,000-4,000 per month on holidays and hobbies, albeit with a likely tail-off in later years,
- He is due to receive a full State Pension from age 66, worth a projected £12,000 a year. That leaves a £12,000 shortfall to his essential spending needs,
- Rather than using his entire pension to purchase an annuity, he instead crystallises £300,000 (i.e. half of it),
- Of this, he’ll receive a tax-free lump-sum of £75,000 (25% of £300,000), whilst using the balance of £225,000 to buy an annuity. On the same 6.7% rate as previously, this will provide an annual income of around £15,000 a year gross, or £12,000 after tax – he’s now secured sufficient guaranteed income to at least meet essential spending needs for life,
- Meanwhile, the remaining £300,000 pension savings (from which he can still take a further 25% tax-free cash) plus the £75,000 cash in the bank can be put towards Jack’s discretionary spending needs.
The above represents a compelling mix of guaranteed income via the annuity purchase and flexibility via the residual pension savings which remain invested and can be subsequently accessed via drawdown.
There is also a non-financial benefit to this. As mentioned earlier, ‘retirement is hard to do’. You’ve spent your whole life saving and seeing the (wealth) line slope upwards– switching to a period of decumulation and seeing it gradually whittled away is emotionally difficult.
This is where an annuity/drawdown blend can help – the safety net of knowing you’ll always have a base level of income to cover essential outgoings makes it easier to go out and spend the rest of it, i.e. to actually do the ‘bucket list stuff’ you’ve been planning.
Conclusion
Annuity sales have risen sharply over the last year, and we think that’s justified – with rates back at normal levels, annuity purchase, either in isolation or blended with a drawdown strategy, is a good solution in certain circumstances. Ultimately, it comes down to your objectives and risk profile.
