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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 }
  • 51 The Rhino May 2, 2018, 9:00 am

    Superb article. I very much like the idea of an annuity as a part of the overall retirement strategy

    The comments are also illuminating. Theres a good few exhibiting a lot of hindsight bias and comparing apples and oranges here. I think that makes the case for annuities more, not less pertinent?

  • 52 oldie May 2, 2018, 9:26 am

    Excellent and readable article. Shows for me the potential value of different and independent asset/income streams across the portfolio.

    Although wrong to let investment decisions be driven by taxation , is there an issue of any income being taxable directly, whereas there any capital could be managed to a degree by realising any gains/losses on an annual basis and using the capital allowance?

  • 53 John B May 2, 2018, 10:25 am

    @oldie One of the problems with pensions is that capital gain on investments becomes income on withdrawal. You can argue that unsheltered investments can keep deflating their capital gains tax burden at £11700 p/a, or just paying the tax at 10%, while from a pension you pay tax at 20%

    For 300k of equity unsheltered, earning 3.5% dividends and 4% capital gain before inflation, you can offset all 22500 of returns against income and CGT taxes, provided you have no other income.

    For 300k in a pension, you can get 5625 tax free, but pay 2130 tax on the 10650 over your income tax allowance. (But this applies whether you draw down your pension or buy an annuity, but you’d lose the 0% Inheritance Tax advantage with the latter.

    400k is the point at which dividends can’t be covered by allowances, and you’ll be paying £500 CGT a year

    Of course ISAs avoid it all, but the takeaway point is that might be a mistake feeling you need to get all unsheltered funds into pensions.

  • 54 Mark Meldon May 2, 2018, 11:03 am

    I have found it very interesting to see the various comments; there seem to be a few threads appearing and some might be looking through the ‘wrong end of the telescope’ in my view.

    For example, I think that the 2015 pension reforms have, perhaps, distorted the view of what pension funds are because of the ‘inheritability’ of the funds. This is undeniably very attractive and has been a key driver of many client choices over the last three years. But, a pension fund is there to provide you with a pension, period! If you are in the fortunate position of having a private pension fund that you don’t currently need you will recall that this has been built up with tax-relieved contributions and has been invested in a virtually tax-exempt environment. I’m not sure that it was George Osborne’s intention to create a ‘wealth transfer mechanism’ by allowing benefits to pass to the next generation (often tax-free) as the sole reason for the so-called ‘Freedoms’. Sure, if you are wealthy enough to take advantage of this then you should, but most people are not in that position.

    Oddly, the sales of guaranteed whole of life insurance policies hasn’t increased since 2015 (these provide a certain tax-free lump-sum on death if the plan is written in trust); there is an argument that those who really ‘want to pass my money on to the children’ and ‘don’t need my pension fund’ should be flocking to buy these secure life insurances. Then they can draw out their Pension Commencement Lump Sums and hand it over to the kids tax-free today – so they can hear them say ‘thanks’ whilst they are still alive – and drawdown an income they ‘don’t need’ and pass that on too. Sure, you have to pay premiums for a whole life policy, and these things can be (very) expensive, but they work.

    Is the truth of the matter that, quite rightly, people do think that they will need their ‘unwanted’ pension fund eventually? And they don’t really mean to make their 50-60-year old ‘children’ millionaires when they die? I’m not sure that many people have really thought this through, but that’s just my opinion this morning!

    The other main thread is that flexi-access drawdown is clearly superior to an annuity. That’s an unfair comparison. True, it might be ‘safe’ to rely on an income yield of, say, 3.5% from your underlying investments but that isn’t a certainty. If you have a £500,000 SIPP fund yielding 3.5% then you might expect (I’m ignoring tax here) an income of about £17,500 per annum. That’s great, but what if your investments fall in value by, say, 25%? You then have £375,000 and that will yield about £13,125. Sure, markets might recover, but you don’t know that. With an annuity (or ‘final salary’ scheme), for better or worse, ‘what you see is what you get’.

    Many of my clients chose a combination of retirement income streams, mixing guaranteed annuities as their secure income and their SIPP as their unsecure income. I think that can be very comforting.

    What I do, just as an aside, and this is (or should be) commonplace IFA advice, is to ‘park’ 2-3 year’s worth of my client’s income requirements from their FAD pension just in the SIPP bank account to create a kind on ‘income reservoir’; you can cope with bumpy markets if you have this ‘breathing space’. Dividend continue to accrue to the bank account, thus extending the period of relatively ‘safe’ withdrawals. This does work well in practice, I find.

    A few years ago, I had dealings with a chap who had a ‘SIPP’ with a large life office. It wasn’t really a SIPP as it was wholly invested in the life offices funds. He started off using the original drawdown facilities (they have been around for 20+ years), with a fully invested fund of £650,000 or so. He took his 25% tax-free cash of £162,500 at the outset and, basically, wasted that on living the high life instead of eliminating his interest-only mortgage – the money was long gone. He was drawing out, if I remember rightly, just under 5% per annum from his fund (so about £24,375 per annum, gross, on a fund of about £487,500 at outset) all of which was invested. He was a DIY investor and had never used an IFA, ever. He never changed the underlying investment choices, never read the annual review documentation, never reviewed his withdrawals, had no ‘cash reservoir’, never did anything. He set up his drawdown in, I recall, 1998. When he came to see me in 2009 his fund stood at £140,000 – he just could not understand why (at all!) it had gone down so much and his physical health had significantly deteriorated. He and his wife were suffering from severe ‘SIPP anxiety’ and didn’t know what to do.

    Remarkably, we were able to source a medically underwritten guaranteed annuity for them offering a rate of about 7.22%, so that gave him and his long-suffering wife a secure income (to which the wife was particularly attracted) of around £10,100 per annum gross. Thankfully his state pension had just started, so he ended up with about £20,000 a year secure income (IIRR). ‘That’s nowhere near enough’ he cried (even though we gently pointed out that he had all the ‘stuff’ he could ever need – he didn’t take that well) and shuffled off into the distance.

    A few months later, we were made aware that he had arranged a substantial equity release plan. I’m not a big fan of equity release and choose not to offer advice in this area (I know someone who does, and very well), but it has a role. We subsequently had a conversation with the chap who admitted that this was arranged just to pay off his outstanding interest only mortgage and would also give him about £250 extra a month to spend.

    We had no further contact with the chap, but I did discover that about three years later the lovely house he and his wife once owned in the West Country had been sold and a mutual acquaintance told us that he ended up in a small flat on the Dorset coast.

    Lot’s of ‘ if I hadn’t done that and done this instead’ there! So, be careful with your drawdown plan, especially after a good run in the markets!

  • 55 John B May 2, 2018, 11:38 am

    @Mark generally when equity falls, dividends fall less, and of course bond value falls do not affect their income. So yields rise in depressed markets.

    You said earlier “for a 60 y/o woman an annuity purchase price £1,500,000 – gross RPI-linked annuity £35,450.04 per annum”, so they’d need £750k to purchase an annuity to match the £500k SIPP in drawdown. A 50% bigger pot is pretty resilient to market fluctuations. You’d have to ask whether peace of mind is worth the extra cost.

    For your anecdote, the 11 years you quote had 2 market crashes, I guess he’d have to be drawing £25k fixed each year, not 5% variable, but I still marvel at the capital loss, as £15k of it should have come from conservative 3% dividend rate. His £140k would probably have made more than 7% annually from 2009 in our bull market. http://www.swanlowpark.co.uk/ftseannual.jsp shows 6 years with double digit growth, 2009 had 30% alone.

    Timing is all in markets, so I’m wary of anecdotes, as the one thing annuities can’t do is remove timing risk on their purchase.

  • 56 The Rhino May 2, 2018, 11:47 am

    @JB – could you buy a ladder of annuities as you age? with those annuities existing alongside a drawdown?

  • 57 Mark Meldon May 2, 2018, 12:14 pm

    @John B

    It’s a true story, really, he was invested, from memory, in a pretty ropey selection of insurance company funds. My story isn’t penny perfect, but it’s close enough as an extreme example.

    I’m an ‘agnostic’ on all of this. Neither annuities nor drawdown are ‘better’ – they both have a role!

  • 58 The Investor May 2, 2018, 12:26 pm

    @TheRhino — That’s currently what I think I’d do, and a solution that might suit many Monevator readers. Well, not a ladder exactly (that is when bonds run to term and are recycled) but rather phasing into annuities as I aged.

    So for instance I might look to secure my minimum income floor first: http://monevator.com/secure-retirement-income/

    … and then buy more tranches of annuities after 5 / 10 / 15 years?

    It doesn’t solve the complexity problem, but it would reduce some of the market timing risk.

    I have no idea if it’d be financially optimal-ish (haven’t modeled etc) but unlike many it seems I am most interested in the greatest chance of a good outcome in my old age, not the optimal odds for the theoretical best outcome. And “good outcome” includes minimizing risks of emotional downsides and regret. 🙂

  • 59 Mark Meldon May 2, 2018, 12:42 pm

    @The Rhino

    There are also fixed-term annuities. These generally pay a fixed income for, say, 5 years and then you have a ‘guaranteed maturity value’ and repeat the exercise. They can be useful if your circumstances change, but annuity ‘rates’ might move against you (but they could improve). They are comparable to, but not the same as, a guaranteed lifetime annuity. They were popular about 8-10 years ago as, I cynically say, they allowed IFAs another fee-earning source!

  • 60 Tony May 2, 2018, 12:44 pm

    “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%.”

    This is often overlooked. IMHO it’s scandalous that annuities can be sold without inflationary increases and so devalue heavily over their lifetime. Imagine if your state pension never increased. Once you’ve decided on an annuity, you have to further decide/gamble how many years you will live before an lower initial inflationary one proves better value than a fixed annuity. Many people, even with advice, aren’t able to make that sort of informed financial decision and just go for the higher initial figure.
    Separately, one advantage not mentioned, although someone alludes to it, is mental capacity. Presently, one in six people get dementia by 80. Of over 65s, 7% have it. One in three born since 2015 will get it during their lifetimes (subject to cures being developed). This website is brilliant for those who wish to and have the ability to run their own affairs to a high level. But there’s a material risk that we will be incapable of doing so. So unless you have a portfolio that will never need adjustment or rebalancing, annuities have the advantage it’s taken care for you and that additional risk is removed.

  • 61 Vanguardfan May 2, 2018, 3:13 pm

    @tony, I used to think the same as you, why would anyone want a flat annuity? Recently however I’ve read evidence that spending needs tend to steadily decline with age. This would give a good reason to go for a flat annuity – more income when you need it.

    I find it fascinating that this topic has generated so many comments so quickly.

    Only inheritance tax trumps it as a comment-generating topic! Of course, the topics are inextricably linked – especially with the new ‘pensions as perpetual generational wealth management vehicles’ policy which, I would argue, was indeed an intentional part of Osborne’s plan.

    I find it hard to comment on the annuity debate, because I have the security of enough in DB and state pensions to provide a very comfortable income floor. I don’t honestly know how I’d feel if I didn’t. I would argue however, that the main problem with annuities is their expense. So the people who can afford them are actually those that need them least.

  • 62 Mark Meldon May 2, 2018, 3:35 pm

    @Vanguard Fan

    You are in an excellent position – inflation-linked (to a greater or lesser extent) income from the state & DB pensions is a kind of paradise. DB pensions are, however, in terminal decline and most people ‘coming up’ will have to rely on the vagaries of DC accumulation and then the decumulation paradoxes in the here and now and into the future.

    I have arranged combinations of annuities/drawdown in that past; the last time we ended up with one fixed annuity, one escalating at 3% per annum compound and one linked to RPI and a meaningful flexi-access drawdown pot for those ‘little extras’.
    Something else you say is true, too.

    In my experience retirees have a bit of a splurge for a year or two, then settle down when they realise that they probably won’t ever need a new sofa again and have all the ‘stuff’ they need and then nearly always end up with excess income over expenditure (oddly enough, that can worry people too in old age!). I’m always amazed as to how little income people manage on in later life.

  • 63 Vanguardfan May 2, 2018, 3:56 pm

    @mark. Yes I’m well aware of my privileged position. I also think the DC arrangement for pensions places so much burden on the individual as to be almost cruel. I do think it’s one reason we won’t see the end of the state pension though.

    I agree with the low income requirements of the elderly. I looked after my elderly mother’s finances and even with substantial home care costs, income exceeded expenditure comfortably. And even in the ‘young elderly’ phase, the appetite for ‘stuff’ and eg home remodelling just seems to vanish.

  • 64 Vanguardfan May 2, 2018, 3:57 pm

    In fact, I don’t think DC pensions should even be called pensions, it’s very misleading. ‘Retirement savings’ would be more accurate.

  • 65 Tyro May 2, 2018, 5:17 pm

    On inheritability of pensions: this has only been in place for what, a couple of years or so? and I gather there’s already a growing view in policy circles – across the political spectrum – that it’s probably not politically sustainable. So I wouldn’t bank on it being still in place in 20 or more years’ time, when one falls off the twig.

    On the dementia point, I’ve just finished reading Jay Ingram’s book The End of Memory: a Natural History of Aging [sic: US spelling] and Alzheimer’s, in which he claims that nearly one in two over 85 year-olds has some form of dementia.

    I wonder if it would make sense for those of us who’d like our children to benefit from any ‘extra’ DC pension to use FAD initially, but put the amounts drawn down into the pensions of one’s children, and then at age 80-85 or so to annuitise the rest?

  • 66 Factor May 2, 2018, 5:21 pm

    Echoing what has been said variously in the Comments here but put succinctly, something that is a no-brainer now will perhaps, sadly, not be if you have become a “no-brainer”. Personally, I can think of no good reason for anyone not setting up a Power of Attorney (I’ve done it), and it should be sooner rather than later.

  • 67 ermine May 2, 2018, 5:27 pm

    I am old enough to remember inflation of < 25% and interest rates of 15%, and these things harm annuity incomes. That's not a reason to eschew annuities, but to keep them as part of the mix. Economies are cyclical, though the various cycles have different periods, I don't find it so hard to imagine 25% inflation, after all, there are some things from the 1970s heaving back into view in the UK political landscape.

  • 68 dearieme May 2, 2018, 5:42 pm

    “IMHO it’s scandalous that annuities can be sold without inflationary increases”: yeah, letting people have the freedom to buy the annuity they want is scandalous. How bloody dare they?

  • 69 Aron May 2, 2018, 5:43 pm

    I don’t really have anything to add to the conversation topic because I’m no where near that age yet.

    Just wanted to say that once again Mark it’s a great article, extremely engaging and informative!

  • 70 dearieme May 2, 2018, 5:56 pm

    “I also think the DC arrangement for pensions places so much burden on the individual as to be almost cruel.” I incline to that view too: it’s particularly hard on people with no experience of managing money, and more generally on the ignorant and dim. And we are all at risk of becoming dimmer.

    Still, it’s rare to see any constructive proposal on how to ameliorate the problems whether it be for people in their sixties or their eighties.

  • 71 W Neil May 2, 2018, 6:30 pm

    @Mark Interesting article thank you.

    “If you have a £500,000 SIPP fund yielding 3.5% then you might expect (I’m ignoring tax here) an income of about £17,500 per annum. That’s great, but what if your investments fall in value by, say, 25%? You then have £375,000 and that will yield about £13,125. Sure, markets might recover, but you don’t know that. With an annuity (or ‘final salary’ scheme), for better or worse, ‘what you see is what you get’.”

    I think this may even understate the downside. If we aim for a safe withdrawal rate of 3.5% over a period of 40 years, to achieve this may require 80%+ equity exposure, and possibly a rising glide path to 100%. At which allocation a portfolio fall of 40% is not totally out of the question; a real problem if it happens early in drawdown and hasn’t at least been notionally planned for with a ‘what if’ scenario.

    For a long horizon appropriate for FIRE, I am not sure inflation linked annuity rates pay enough. But I can see why they may have a place in a portfolio which is sufficient to utilize annuities to create an income floor, and where the income floor is more of a priority than the maximum potential income.

  • 72 Gadgetmind May 2, 2018, 6:37 pm

    I am now retired and have never known anything other than defined contribution AKA “saving my own money for my own old age”. This is savings in a pensions wrapper, so yes, it’s a pension. It may take some managing but we’re all adults and should be able to grasp the fundamentals of asset allocation, or just stick it all in the pension provider’s default fund, many of which are pretty decent TBH.

    Defined Benefit is dead, and should have been killed 2-3 decades earlier as it’s an unsustainable promise. Ditto the state pension and I have £0 in my retirement plans for that as anything else would be unrealistic. I regard the many 10s/100s of thousands I have paid in NI over the years as being totally lost and inaccessible.

  • 73 The Investor May 2, 2018, 7:08 pm

    “IMHO it’s scandalous that annuities can be sold without inflationary increases”: yeah, letting people have the freedom to buy the annuity they want is scandalous. How bloody dare they?

    Can we have fewer of these argumentative quips please, they don’t add anything of value.

  • 74 Naeclue May 2, 2018, 7:08 pm

    @John B, in your analysis you have forgotten about pension tax relief. In reality your £300k in a pension fund would have been topped up by 25% tax relief, so you will have £375k in the fund compared with only £300k outside, possibly less if you had to pay income or capital taxes on accumulating it.

    If you do your calculations again, but comparing flexible access drawdown from a 375k pot, you should find that the pension fund works out better.

  • 75 The Borderer May 2, 2018, 7:11 pm

    One potentially interesting use that an annuity might be put to is a buffer source of income if pursuing a dynamic withdrawal strategy. Say you adopt Guyton and Klinger’s Decision Rules, but find that, for example, not increasing your drawdown by inflation because the portfolio value has decreased creates an issue with sums available, then an annuity steps in. However, when the market is doing well, the annuity is diverted into (say) an ISA, savings account &etc.

    This way, you can continue to comply with the ‘rules’, but still achieve a more constant income.

  • 76 Naeclue May 2, 2018, 7:22 pm

    Like others, when I crystallised my SIPP, at age 55, I obtained some annuity quotes, flat and indexed and found them poor value. I am curious about fixed term annuities though and did not think to ask about them. How much would a 10 year level annuity cost for the average 60 year old? I am curious to know whether it would give a better income than a 10 year gilt ladder.

  • 77 Kraggash May 2, 2018, 8:18 pm

    Annuities would be more interesting to me if they covered ALL risk – inflation included. As the article says: “,,,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%”

    Why are they so expensive? Because they are covering the (considerable) risk of higher inflation. If the risk was not high, they would not be so expensive (I assume).

    With drawdown for a substantially equity based portfolio, you have a reasonable hope that inflation would cause asset appreciation, and consequent dividend increase.


  • 78 Richard May 2, 2018, 8:49 pm

    Considering all the posts on MSE and the like asking for ways to pass on ones wealth to ones children, I’m not so sure this is that far from peoples minds (even for tiny sums). Even my parents, who are not retired and not rich and not really that interested in all this are worried their children won’t inherit their house. They see it as part of the rich mans game and to have a chance of your family ever playing it, you need to play by rich men’s rules and ensure your children get a max payout to elevate them upwards.

    I have read somewhere that you would be better off giving your kids the cash you would have spent on private schooling (assuming you are going through hardship to school privately) than privately schooling as it will have a much bigger impact on their and your descendants life (assuming they won’t just blow it on a flash car). Think what a 50 year old millionaire could offer their grandchildren as a start in life……

  • 79 Brod May 2, 2018, 9:21 pm

    Great article. Thank you very much. The comments are very enlightening too.

    We’ve had a ten year equity bull run leading to some very inflated valuations and depressed bond yields giving awful looking annuity rates, both caused by global ZIRPs. I’d like to see the comments if the same article were published after a 40/50% crash and a stagnant market for, oh, I don’t know, a decade or so while the world works off it’s debt binge. Reckon the annuity insurance policy won’t be considered so bad then.

  • 80 Hariseldon May 3, 2018, 12:26 am

    @JohnB. My comment about choosing between annuity or income drawdown from an equity portfolio in 2007 , was not about choosing 2007 as a starting date for an annuity comparison, it was when I retired!
    By early 2009 I had a near 50% reduction in the portfolio but it recovered strongly. For many people that would not have been tolerable and the annuity is the certain choice but in this case the equity portfolio has proved financially more rewarding.

    For many people the security of an annuity is very comforting and it’s the right choice, for others the more enterprising appproach is attractive. I imagine monevator readers are a subset of the population that are more likely to consider drawdown vs annuities in an informed manner.

  • 81 Gone2thegym May 3, 2018, 7:55 am

    Have been reading and praising Monevator for years. Finally my first post. A great easy reading article that has helped me reconsider the benefits of an annuity as retirement seems closer than when I started work 30 years ago for a Life company and all the subsequent changes to the industry.

    I do have an unrelated question for readers. As a percentage how much of your overall savings/ investments should be held as easy access cash. Any rules of thumb?


  • 82 Scott May 3, 2018, 12:11 pm

    @Gone2thegym – are you asking from the position of a retiree? Everyone should have an emergency find to tide them over (e.g. for at least a few months in the event of job loss, or for large unexpected household expenses.)
    In retirement, I have three years in cash, with another two years in bonds, the rest in equities. But I’m still youngish, and could work again if markets tanked. If I was nearer 60, and had no DB pension coming soon, I’d be holding more cash/bonds.

  • 83 John B May 3, 2018, 12:56 pm

    My cash is hardest to access, as its in p2p with extraction times in months. Otherwise I have no cash buffer, but I could put £10k on credit cards and sell equity to cover them. Now of course I can withdraw and put back in my ISA without penalty. (Or I could ask my late 80s mother, who has FAR too much in cash)

  • 84 Gadgetmind May 3, 2018, 12:59 pm

    We keep some cash to hand but also have a fully-offset tracker mortgage so could access up to £100k within a day if we needed to. We also have a lot of “unwrapped” equities and bonds (about 50:50) that we could use, but these are designed to generate tax free income as we slowly “ISA up” over 10+ years.

  • 85 W Neil May 3, 2018, 1:39 pm

    @Gone2thegym Not wanting to divert this thread away from annuities, but if you are going to hold cash and wonder how much, you need to consider the target withdrawal rate for your whole portfolio (e.g. 3.0%, 3.5%?) and for how long your portfolio needs to be sustainable (FIRE or normal retirement age), both of which are interrelated, and what is the rest of your allocation – all equities or an allocation to bonds as well as cash? Cash can be a significant drag on expected returns, especially long term, and holding too much cash could derail your anticipated SWR. This may give some food for thought https://earlyretirementnow.com/2017/03/29/the-ultimate-guide-to-safe-withdrawal-rates-part-12-cash-cushion/

  • 86 dearieme May 3, 2018, 4:40 pm

    “these argumentative quips please, they don’t add anything of value.” I think you’re wrong there. I pointed out that the poster seemed to believe that he axiomatically knew what was better for people than they did, and so he wanted a particular commercial activity banned. In other words, I was speaking up for liberty and the free market, he for some variety of authoritarianism. I can see, however, that my views might not appeal to everyone.

  • 87 Tony May 3, 2018, 5:28 pm

    @ dearieme Not at all. That’s not what I wrote nor implied. I’m making a similar point to your post 70. The free market is great for the informed and educated (those who read this site). Not so good for the average person or the time poor. FS and money matters generally are full of areas where the consumer only gets a good deal if they’re informed and pro-active. From zero interest savings accounts, energy tariffs to high fees on financial investments (the key point I’ve learnt from this website and Lars and Tim Hale’s books!) Lots of people aren’t educated or informed enough to evaluate and make rational decisions. Noone is going to ban any type of annuity. I only talk through the experience of family members. A cursory letter from their insurer and equally cursory one from an IFA outlining a fixed annuity and inflationary increased one. I don’t know enough about what regulation is in place and if and whether it should be improved but what I can say is they weren’t in a position to make an informed choice. There’s a reason the state pension does not come with two choices- fixed or increasing.
    More generally, thoroughly endorse the comments from Factor at 66 about powers of attorney. The sort of person using this website is the sort who will easily be able to fill it in themself. The Office for Public Guardian have a free helpline. But you must 100% trust the attorney.

  • 88 JimJim May 3, 2018, 5:36 pm

    I very much like this article, most people, in my experience, do not have the foggiest idea of how to manage money when they are working let alone when they retire. P.I’s are an entirely different breed. Most have a good handle on where they stand and what will be right for them at any time let alone in retirement. Forward thinking is not a thing everyone possesses otherwise how would anyone make any money at all in a stock market (losses and gains are often blamed upon sheep following the herd???) I know that an annuity is not what I need… “Final salary pensions are, in practice, annuities.
    So is the state pension.” I have enough of that already. So the market is the only other thing I need (Investment property is something I will offload as I age…I hope). It is a risk, but only for part of the plan, not all of it. What is the worst that could happen?

  • 89 Factor May 3, 2018, 6:04 pm

    @Tony (87)

    All the P of A forms, for both the Property and Financial Affairs type and the Health and Welfare type, are “downloadable” from the website https://www.gov.uk/power-of-attorney, can be completed online, and have built in safeguarding. I have both types in place.

  • 90 The Rhino May 3, 2018, 9:21 pm

    I’m currently seeing power of attorney going badly wrong on my in-laws side. With great power comes great responsibility as they say. I would reiterate the 100% trust point. Possibly up it to 110%?

  • 91 Grislybear May 3, 2018, 9:43 pm

    @ Mark, great blog and nice historical detail. There is something about those level annuties (not inflation adjusted) that troubles me. I wonder if a pensioner bought one in 1970 what would be his spending power in 1980.

  • 92 Naeclue May 3, 2018, 11:26 pm

    I have also witnessed POAs go wrong. Trust is a must, but so is competence. Also worthwhile thinking through the repercussions of appointing particular family members as POAs and any likely bad feeling this may cause.

  • 93 The Investor May 4, 2018, 12:32 am

    @dearieme — It’s not the intent of the message, it’s the short retort form. The Internet is full of people just sniping back and forth at each other. If you scroll down this thread you’ll see lots of people with a different range of views articulating their position. I don’t deny that sometimes in real life pithy is effective but on the Internet it’s just a bitchy back and forth. We’ve all done it at times, but some seem more prone to it than others. This thread is great, and I had no desire to see it get snarky.

    That’s enough about that, let’s keep to the topic please all. 🙂

  • 94 Lad's Dad May 4, 2018, 1:27 am

    I can’t help but wonder whether the minefield of utilising ones pension, i.e. drawdown vs annuities (each with their associated risks, varieties and associated conplexities), is a major factor in “one more year” behaviour.

    I know my own father is kicking the proverbial retirement can down the road partly to avoid making such crucial decisions.

    This is exacerbated by the fact he is c.7 years older than my mother. There is therefore a significant burden on making the right decision for c.10 years beyond his own life expectancy.

    On reflection, probably a position where they would significantly benefit from paying for some professional IFA advise, I think.

    Great debate by all BTW

  • 95 Gone2thegym May 4, 2018, 8:22 am

    Thanks for the input to my question about holding cash really helpful. I’m nearing 50 and taking stock of where all the time and money went since I started work. Trying to be more focused around how I manage my savings eg not leaving far too much in my current account (schoolboy error).

  • 96 Mark Meldon May 4, 2018, 9:06 am

    @The Rhino

    Hmmm..LPA’s (or their predecessors, EPA’s) can be problematic. I was a co-attorney with my mother for my late grandmother last year and she had a LOT of work to do at first when the time came to ‘switch on’ the LPA. Things did settle down and without it we wouldn’t have been able to sell Nan’s house and deal with her pensions – she lived to well over 96 and received a civil service pension for 18 years longer than she worked + state pension at Lord knows what cost.

    I have had experience where three siblings were attorney’s for their Mum. They could just not get on and agree about anything – eventually they were fired by the Court of Protection who appointed a Swansea based solicitor (with a minor criminal record!) as her Deputy instead.

    Usually, it is one’s spouse/partner that will be the ‘lead’ attorney, but remember that they are likely to be about the same age as you, so appoint a younger attorney, too. Often that will be a son/daughter (if you have children), but what about the influence of the dreaded son/daughter-in-law?

    I usually recommend a ‘neutral’ referee, such as the family solicitor as a back up as that can add a further layer of protection.

    Sadly, death is just as likely to cause arguments in families about money as divorce!

  • 97 Factor May 4, 2018, 12:13 pm

    @ Mark (96) et al

    It is perhaps worth clarifying that a power of attorney ceases automatically on the death of the person for whom the attorney is acting. Also, be aware that there is a different process for powers of attorney in Scotland and in Northern Ireland.

  • 98 ermine May 4, 2018, 12:40 pm

    Forward thinking is not a thing everyone possesses otherwise how would anyone make any money at all in a stock market (losses and gains are often blamed upon sheep following the herd???)

    Although TI has made the case reasonably well that buying and selling may be a zero sum game, the companies we invest in deliver some value to their customers. If we all agreed to sit on our backsides and tumbleweed blew through the exchanges I’d still hope to make some money from my existing holdings 😉

  • 99 JonWB May 4, 2018, 1:37 pm

    @Mark Meldon

    Thanks for the article.

    Why should you annuitise from a pension in preference to annuitising from an ISA (or any other capital source)? I’ve never seen anyone cover this point and I’m just wondering if it is something you have done or considered as an IFA. The reason I ask is that with the ISA allowance going up to £20K and the annual allowance coming down to £40K (or 10K for very high earners), the relative size of the pots for SIPPs and ISAs will probably converge compared to what they have been historically. This will likely accelerate if the flat rate of pension relief of 30% comes in, rather than the really high levels achieved through salary sacrifice with Employers NI added on top.

    To me, it just seems strange to automatically earmark the annuitisation of capital that can pass tax free to descendents (e.g. pensions) rather than considering annuitising capital that doesn’t pass tax free to descendents (e.g. ISAs), subject of course to IHT thresholds.

    I also think that for some individuals they would probably be better off downsizing and releasing equity in their homes and annuitising that capital, rather than annuitising from the pension just because ‘annuitisation from pensions is what you do’.

    I am making the assumption that ISA capital (or capital released from downsizing) converted to an annuity is not subject to income tax, but I don’t know if that is true.

    I’d really welcome your thoughts on this.

  • 100 Mark Meldon May 4, 2018, 1:55 pm

    @John WB.

    You can buy a ‘purchased life annuity’ (PLA) with non-pension fund money but the market for these is tiny, with around 100 arranged each year in the UK (or so I understand). Not so many years ago, when interest rates and inflation were higher there were nearly 100 life offices offering PLA’s, now there are only two actively in the market – Aviva & Canada Life.

    Much of the income is treated by HMRC as return of capital with only the ‘interest element’ potentially taxable, although this might be covered, in part, by the ‘personal savings allowance’. Non-taxpayers will receive a gross income. The interest element decreases with age, so many PLAs are free of tax in payment.

    You can have escalation on the payments of up to 10% per annum (certainly with Canada Life), a guarantee period (5 years, for example) meaning that if you die after 3 years the income will continue for a further 2, and ‘capital protection’. This is where the balance of the purchase price is refunded if it hasn’t been paid out as income yet.

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