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Annuities: What’s so bad about a guaranteed income for life?

Photo of Mark Meldon, IFA

This guest post is by Mark Meldon, an independent financial advisor (and Monevator reader!) who we’ve noticed talking a lot of sense over the years.

With more and more Baby Boomers reaching retirement, I thought I’d mount a defence of the much-maligned annuity as a solution to the question of after-work income.

As an IFA, I have seen a big increase in the number of enquiries from individuals wanting annuities rather than ‘flexi-access drawdown’ this year, and I think I know why.

But first, a little bit of history.

A serious business

…but if you observe, people always live forever when there is an annuity to be paid to them; and she is very stout and healthy, and hardly forty. An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it.

– Jane Austen, Sense and Sensibility (1811)

What Jane Austen said over 200 years ago is still quite true today. Those who purchase a guaranteed income for life via an annuity – whether through using their pension fund to do so or, much more rarely, by spending their own money – tend to enjoy better-than-average health and suspect that they will live for a long time.

Otherwise why would they do it?

They also appreciate something often misunderstood by most of the population – you will live longer than you think, unless you are very unlucky.

Nowadays, even those suffering poor health or making poor lifestyle choices – smoking is an obvious example– can get recognition for their reduced life expectancy with underwritten annuities.

Annuities have been around in one way or another since Roman times and were very popular following the founding of Equitable Life in 1762 and the establishment of hundreds of competitors in the centuries that followed. Even the government sold annuities up until 1928.

Back in the 1970s and 1980s, there were well over a hundred life offices arranging annuities1. Now just a handful remain – we will see why that is a little later!

So, what, exactly, is an annuity?

Upside down life insurance

One way to think about annuities is that they are the reverse of a life assurance policy.

If you buy a life assurance policy you make small regular payments to your life office and, should you unfortunately die during the term, they send you a big cheque.

The reverse is true with an annuity. Here you send the life office a big cheque and they send you little bits of money until the day you die.

Most annuities are fixed in payment, but those that increase by a fixed percentage (‘escalation’) or by reference to the RPI (Retail Prices Index – a measure of inflation) are available and are a sensible choice if you can afford one.

We can see, therefore, that an annuity insures the annuitant against longevity risk, because of the guaranteed lifetime income stream.

You simply don’t get that with any other kind of investment – period.

I have arranged hundreds of annuities over the years, nearly all of them pension-funded ones. I can honestly say that nobody, ever, has been unhappy with the annuity. These individuals were not fazed by the ‘annuity puzzle’.

The annuity puzzle

In recent years, lots of economists have spent a great deal of time wrestling with what they like to call ‘the annuity puzzle’.

This so-called puzzle was first drawn attention to by Franco Modigliani in his Nobel Prize acceptance speech in 1985.

Modigliani said:

“It is a well- known fact that annuity contracts, other than in the form of group insurance through pension systems, are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill-understood.”

What Modigliani said a third of a century ago remains true today.

According to Shlomo Benartzi, Alessandro Previtero, and Richard H. Thaler2:

‘Rational choice theory predicts that households will find annuities attractive at the onset of retirement because they address the risk of outliving one’s income, but in fact, relatively few of those facing retirement choose to annuitize a substantial portion of their wealth.

Adding some behavioural factors only deepens the puzzle because annuities have the potential to solve some complex problems with which individual struggle, like when to retire and how much they can spend each year in retirement, and thus they might be expected to be attractive for that reason as well.’

Benartzi, Previtero, and Thaler go on to say something very important and relevant to today’s ‘at retirement’ sector:

‘In addition to these arguments based on rational choice theory, certain behavioural factors should, in principle, increase the attractiveness of annuities.

As a first approximation, middle-class American households spend what they make. Whatever saving takes place occurs via pensions and paying off home equity, and the latter vehicle seems to have become much less fashionable in the last decade.

If the primary income earner in a household retires, the ‘spend what you make’ rule of thumb is no longer available. Instead, households who choose not to annuitize must learn a new skill, namely calculating the optimal drawdown rate over time.

Given the complexity of this optimization problem, it is not surprising that retirees might err, either by under-or overspending. These errors can easily be exacerbated by self-control problems if households have trouble sticking to their drawdown plans, either by spending too little or too much.

By converting wealth into an annuity, individuals and households can simultaneously answer the conceptually difficult question of figuring out how much consumption is sustainable given the age and wealth of the consumer and provide a monthly income target to help implement the plan.’

I like that – a lot! This is, after all, exactly how ‘defined benefit’ (aka ‘final salary’) pensions and our state pension works – a guaranteed income for life, with some inflation proofing, too.

They can give a ‘baseline income’ covering regular bills, and other pension funds and investments can cover other expenses as they arise.

So why are annuities still so unpopular?

Annuities are not at all sexy. They are also very much a one hit wonder as far as IFA and financial services companies fee-earning ability is concerned.

Nor can they help the reckless squander their capital!

Not so long ago I was at a conference concerned with the ‘at retirement’ market. The speakers produced various tax-planning tips, observations on the state of the investment markets and several technical sales techniques, and how much money they were making ‘managing the Baby Boomers money’. Whilst all this was very impressive in its way, and undoubtedly some of the ideas promulgated might work in certain circumstances, I did find the whole day rather discomforting.

When asked, I said how ridiculous it was that the retired had to spend so much time thinking about their investments, taking and paying for advice, and worrying about the stockmarket. I said I thought that for many it would be much better to cover their financial backsides with a lifetime annuity.

A couple of the presenters seemed to question my views and suggested some naivety on my part.

As I trudged across the rain-swept car park I wondered who was right.

Was it them with their discretionary fund management offerings, index funds managed by algorithms (what?), venture capital trusts and offshore investment bonds? Sure, these things can be useful in certain situations, but they all involve risk, sometimes very substantial risk.

Perhaps my line of thinking about how best to secure my clients a decent amount of worry-free lifetime income with at least some of their wealth is rather old-fashioned, but I remain convinced that it has its place for many people.

A 19th Century digression

I need to mention here another long-dead novelist, Anthony Trollope, who was writing his Palliser series of novels about 50 years after Jane Austen wrote Sense and Sensibility.

Since the turn of the year, I have been re-reading these great stories at bedtime – I’m about to start Phineas Redux – and something struck me related to my work.

Trollope’s middle and upper-class characters are always banging on about how much money they have, but, in contrast to the IFAs I met at that Exeter conference, their 19th century fortunes are almost always described in terms of the annual income they produce, not the lump sum.

It seems to me that hardly anybody talks about investments that way now. It’s all about net worth and asset value. I do wonder if asset values have come to play such a big role in modern financial life that we’ve forgotten what those assets are for?

In Trollope’s world, people bought shares purely for the dividend. Now dividends are usually an afterthought, with price appreciation the main goal.

I think that is wrong-headed.

Annuities don’t buy Aston Martin’s

I took a call in my office the other day from a lady seeking help with a pension sharing order following her divorce.

She didn’t appreciate that she won’t be getting a pension when it goes through. She will get an investment account wrapped up in a pension, unlike her ex-husband, who will continue to receive half his indexed-linked final salary pension. This lady was very shocked to learn that she must think about investment, interest rates, longevity statistics and all that kind of thing when her ex doesn’t.

I suspect that she might well choose to annuitise part of her eventual fund in a year or two, as she did understand the guaranteed income for life bit of our discussion.

Yet this lady also helped confirm what I thought was merely an urban myth. A close relative of hers took a transfer out of his employer’s final salary pension scheme just past age 55. He then cashed-in the whole lot – paying away almost half the fund in tax and losing his personal allowance – and blew £160,000 on an Aston Martin DB11.

I said that was completely crazy and she agreed. Apparently, the gentleman enjoys good health, but he sure is going to be income poor when he is 80.

I have no reason to disbelieve this story.

So, what to do when it comes to annuities?

I recommend you think hard about all options when you are nearing retirement and looking at your investment choices:

  • Consider annuities very seriously.
  • Maybe mix and match annuities with other financial arrangements.
  • Conventional annuities are certain! Nothing else is. There are investment linked annuities around, but these are not ‘certain’ in the same way.
  • Annuities don’t cost much to arrange. An IFA will charge to search out the best deal and to set one up – but there are no ongoing fees to pay, as far as the annuity purchase itself is concerned.
  • Most annuities involve no investment risk.
  • If you think you will live forever, an annuity is a great idea.
  • If you think you will die soon, think hard about not buying an annuity.
  • Final salary pensions are, in practice, annuities.
  • So is the state pension.
  • You can use ‘flexi-access drawdown’ as the icing on the cake – but remember it isn’t guaranteed and it costs a lot to run.
  • You say you don’t want an annuity? But do you really want to be invested when you 90 – or a landlord with a portfolio of buy-to-lets?
  • Remember inflation. Even today, with inflation quite low in historical terms, rising prices quickly erode the purchasing power of a fixed income. You can purchase annuities that increase in payment by a fixed percentage – usually with a maximum of 8.5% per annum – or index-linked annuities that are referenced to any increase in the RPI. In many ways, an index-linked annuity would be ideal, but they are very expensive, often reducing the ‘starting’ income compared with a fixed annuity by around 50%.
  • If you are worried about dying sooner than average – and thus subsidising those who live longer than average – consider a life assurance policy for your financial dependants
  • Don’t arrange a single-life annuity if there is someone else financially dependent on you
  • Finally, annuities offer something priceless – peace of mind!

Mark Meldon is an Independent Financial Advisor based in Cheddar, Somerset. You can find out more at his company website. You can also read his other articles on Monevator. Let us know in the comments if there’s a topic you think Mark could cover.

  1. Source: UK annuity price series, 1957-2002, Edmund Cannon & Ian Tonks, University of Bristol & University of Exeter []
  2. Annuitization Puzzles – Journal of Economic Perspectives – Volume 25, Number 4, Fall 2011 []

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{ 111 comments… add one }
  • 101 JonWB May 4, 2018, 2:08 pm

    @Mark Meldon – Yikes, only 100 or so, that really is a very small market. That is really useful information, thanks very much for sharing your considerable knowledge.

  • 102 Lindsey May 4, 2018, 2:18 pm

    Many thanks again for your clarity Mark – I’d no idea that the market for PLAs was quite so minuscule, which does explain why none of Monevator’s well-informed audience had hitherto responded to my plea (#12). I’m hoping against hope they’ll still be available when I’m ready to take that step in a few more years’ time, but if anyone else is ready now the only info I’ve seen is on the HL site and very hard to find, and in the past I’ve seen much more from an IFA (I assume) who was more of a specialist; not sure if I’m allowed to post the name here, or even if he’s still active.

  • 103 Mark Meldon May 4, 2018, 3:40 pm

    Her is a bit more on Purchased Life Annuities – the ‘forgotten annuity’ – which might be of interest (with thanks to my friends at Canada Life for the ‘aide memoire’).

    PLAs are available on a single life, joint life and ‘life of another’ (see below) basis.

    The regular income can be paid for life or for a fixed period (Trollope again https://en.wikipedia.org/wiki/The_Fixed_Period – rather an apt book (which I have yet to read) for the subject in hand!).

    A ‘Life Annuity’ pays an income throughout the life of the annuitant. In the case of a joint life annuity, payments will continue until both annuitants have died.

    The ‘Temporary Annuity’ pays the income for a specified number of years, or until death, if this occurs before the period has expired.

    Main uses for the PLA.

    Apart from providing a guaranteed income from capital, a PLA can have specific applications:

    Funding school fees using a temporary annuity based upon the child’s life. It is possible to receive an increasing income to allow for future fees inflation.

    Enhancing a retirement provision by converting part or all of Pension Commencement Lump Sum (tax-free cash) into a life annuity, which has tax advantages as part of the annuity is not subject to tax.

    When taking early retirement, using a temporary annuity to cover a possible shortfall in income until State Pension Age.

    Funding the premiums of a life assurance policy for inheritance tax payments from a life annuity or temporary annuity, often known as a ‘back to back’ annuity.

    Reducing the value of an estate, thus saving on inheritance tax, by purchasing an annuity.

    Canada Life has a minimum age at entry for a lifetime annuity of 35 attained, with a maximum entry age of 94 years, 11 months. Annuities are arranged on younger lives sometimes as part of a ‘structured settlement’ after a serious injury or illness. There is no minimum age for a temporary annuity and the same maximum age as before.

    Life offices will not arrange PLAs for the over 80s unless they take out one of the two generally available death benefit options.

    A ‘guarantee period’, where payments are guaranteed for a number of years to a maximum of one year less than the duration of a temporary annuity. In the event of death(s), income payments continue throughout the remainder of the guarantee period.

    ‘Premium protection’, where death occurs before the sum of income payments made to the annuitant(s) is equal to the purchase money, this will pay the difference as a lump sum.

    These ‘insurance options’ are paid to the annuitant(s) personal representatives.

    When a joint life annuity is arranged, it can be set up so that income payments continue on a reduced basis on the death of one of the annuitants. With this option, a higher income can be selected to be paid while both annuitants are living. It ensures that the annuitants receive payments which more closely match their needs at the time; normally higher when both partners are living; lower when there is only one. The facility can be designed to come into effect on the death of either person, or designed so that the reduction occurs on the death of one specific annuitant (where a pension might continue, for instance).

    Escalation can be chosen, where the payments rise on each policy anniversary, at a fixed compound rate, sat 5% a year.

    The greater the optional features that are built into the annuity, the lower the annuity.

    The minimum purchase price for a PLA is generally £10,000.

    There are, I think, three main financial planning opportunities where a PLA should be considered; the examples that follow assume that the clients are a married couple (for the sake of clarity).

    ‘Life of Another’. Where a wife is younger than her husband it could benefit her to take out an annuity in her own name, but based on the life of her husband, who will be the annuitant. That way, the policyholder can take advantage of the higher rates which apply to older lives, while receiving the income themselves.

    Also, where the husband is a higher rate taxpayer and the wife pays at the starting or basic rate or is a non-taxpayer, it could benefit the wife to take out an annuity in her own name, but based on the husband’s life. This will ensure that the taxable portion of the annuity income, called the interest element, will not be taxable at the higher rate. It will be taxed at the basic rate (currently 20%), or will be tax free, depending on the tax status of the wife.

    However, where life of another is used and the annuitant (the person on whose life the policy is based on) is older, please note that this could outweigh any taxation or rate advantages. This is because under normal circumstances the older person would die first resulting in the income stopping earlier, unless a life insurance could be arranged to cover this risk.

    ‘Planning for school and college fees’. Where a parent buys an annuity in the name of their child, the income is treated as part of that parent’s income.

    The parent who pays a lower rate of tax should consider buying the child’s annuity, so that the income is subject to tax on the interest element at the lower rate. When capital is gifted to a child from someone other than the parents, such as a gift from grandparents, the income from a PLA subsequently purchased is not considered as that of the parents, but is treated separately under the child’s personal allowance.

    ‘Back to back annuities’. A back to back annuity is one where the regular income received from the plan is used to pay the premiums on a separate life policy.

    Back to back plans are especially attractive where the annuity can be paid gross to a non-taxpaying spouse. The spouse will then have more cash available to fund the life policy.

    As I have said, these things are old-fashioned, but reliable, and hardly ever arranged nowadays – do remember them though!

  • 104 SurreyBoy May 5, 2018, 12:27 pm

    Ive been looking at Investment Trusts for income lately. Im in the accumulation phase but can see the day coming where there is great appeal in switching the various ISA funds into dividend hero ITs. The Greybeard articles informed this thinking.

    In theory (and i know its not guaranteed at all) these Investment Trusts should throw out a starting yield which should pace or exceed inflation over the long term. When markets plummet, i understand the IT reserves are used to maintain dividend flows – so whilst the value of the ITs will tank in a crash, the income should remain there – albeit it may reduce for a while before hopefully rising as markets heal.

    I know annuity represent absolute certainty but would income focused Investment Trusts represent a solution for those who want income but cant face the perceived poor value of gilts?

  • 105 The Accumulator May 5, 2018, 1:43 pm

    @ All – what a great comment thread! Like a bonus article all by itself.

    I helped my mum cover her finances in retirement with escalating annuities covering annual income needs, a small cash buffer for emergencies, and anything left over invested in a LifeStrategy fund. Purchase Life Annuities formed part of the mix. Mum before = highly stressed about finances. Mum after = lives happily within her income, no more stress (about finance).

    I should point out, that while mum is highly capable, she is risk adverse and has zero interest in investing / managing a drawdown portfolio.

    @ Mark – thank you very much for sharing your advice and expertise. It’s instructive to hear your anecdotes, especially because annuities seem a little arcane and much of the debate gets framed in terms of ‘optimisation of theoretical results’ rather than ‘optimisation for peace-of-mind’.

  • 106 Atlantic May 6, 2018, 1:22 am

    @SurreyBoy
    While investment trust companies have reserves salted away to continue to pay dividends, I would have a question mark as to whether they would all typically have enough to continue paying dividends through a prolonged market downturn lasting a few years. Once they’ve used up the reserves they will depend on the current income they’re receiving from the companies they invest in and if that drops then the dividends they’re paying out will drop too. However that said, there are several “dividend hero” investment trust companies that have managed to increase their dividend payouts for decades without a break. I retired 2 years ago and transferred my SIPP into income drawdown, invested mainly in investment trust companies. The balance I kept in cash in the SIPP representing 3 years income (my income needs are modest, this is not a huge amount). While most academic studies are very negative on holding cash, it helps me sleep better at night. I reckon in the event of a market crash, the cash element of the SIPP and the dividends from investment trust reserves would carry me through at least 4 years without having to sell shares.

  • 107 Atlantic May 6, 2018, 1:37 am

    @SurreyBoy
    I forgot to add to my last post that I looked at annuities after going into income draw down. The best annuity quote I got gave an income that was a good bit less than the natural dividend income arising from the investment trust portfolio in my first year of investment, albeit the dividend income is not guaranteed while the annuity is. I do plan purchasing a small annuity at age 65 or 66 using an untouched pension fund to beef up the state pension.

  • 108 SurreyBoy May 6, 2018, 11:48 am

    @Atlantic – thanks. On the point about a cash buffer, i think im with you in that it would help me sleep at night to have one. Ive read various articles on how the buffer is a drag on returns over the long term and so on, but the more i contemplate the practicalities of RE the more benefit i see in sleeping soundly.

  • 109 Kraggash May 6, 2018, 12:02 pm

    @Atlantic “The best annuity quote I got gave an income that was a good bit less than the natural dividend income arising from the investment trust portfolio in my first year of investment”

    A better comparison would be with the income from your IT portfolio PLUS cash buffer. You would need a much smaller buffer with an annuity!

  • 110 Mike May 10, 2018, 1:23 pm

    Never been a fan of annuities. But, this is a thoughtful post…appreciated.

    IF (emphasis on IF) the next 10 year’s market returns were going to be as modest as many (Vanguard, included) predict, I believe your point (to me) would be a Fixed Immediate Annuity is worthy of consideration (I’m a 65 year old, single male…excellent health). That is, protecting a significant % of nest egg from extended or deep bear market would be “cheap” relative to predicted market returns.

    EXAMPLE: A $500k fixed immediate investment annuity would yield 6.61% — $2,800/month…$33,600/year.

    Are we “on the same page”?

  • 111 Nick Lincoln May 12, 2018, 9:56 am

    Short counter-argument: in 1988 a first-class stamp cost 19p. Now it’s 64p. Fixed income = fixed outcome: penury.

    Longer counter-argument: if you think you are going to live an average retirement of c.30 years then drawing on a pot of equities to fund retirement makes sense.

    Ignoring dividends (!) the FTSE-AllShare has never lost money over any rolling 30 year period. In every sense of the word, there is no “risk”. There are just temporary declines, quickly reversed. How the investor emotionally reacts to these temporary declines will determine the investment outcome, not the markets themselves.

    At 4% trend inflation, living expenses more than quadruple over 30 years. That is the reak risk that retirees are exposed to. Over the last thirty years, the total return of the FTSE All-Share has been an annual premium OVER inflation of 6%

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