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 19^th 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 19^th 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. If you need an IFA closer to home, try the directory at Unbiased. You can also read Mark’s other articles on Monevator.

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 [↩]

What caught my eye this week.

One reason I found it pretty easy to rent for so long is that I’ve always done very well for landlords.

My last landlord in particular was a star. He sensibly recognized that his initially fully refurbished property was kept in good shape for the many years we rented it. By the end we mostly chatted over email rather than going through the agents. The rent, which was high-ish when I first moved in, was only raised once in a decade.

He was also flexible in moving me to a one-month rolling contract when I started looking for somewhere to buy after my housemate bought a property and moved on.

And when I completed rather out of the blue and moved, he just let me pay to the end of that month instead of asking me to pay the next month as he was entitled to given the lack of notice, which saved me (and cost him) £1,750.

I was therefore pretty sympathetic to the post at My Deliberate Life defending amateur landlords against some nasty accusations in The Guardian.

The author, a landlord, writes:

I’m not trying to make out like I’m some kind of saint. Obviously I’m in it for the money and it does give a good return. And a lot of these services I’m legally required to provide and rightly so.

But don’t paint me as some kind of demon, or parasite, or ‘feudal incubi’ (whatever that is). I am not any of those things.

The very long post is well worth a read for a pretty balanced recap of the state of the UK housing market.

Personally I think the scales were tipped in favour of buy-to-let landlords for far too long, and that combined with very low interest rates this has taken a generational wealth gap to dangerous levels. The recent tax changes seem to be addressing this.

But in my experience the average buy-to-let landlord is no more a social parasite than an investor in an index tracker funds.

Don’t hate the player, hate the game.

[continue reading…]

Cost is one of the best predictors of return (low = good), so you might think we’d be filling our boots with the new Lyxor Core ETF range.

This is a family pack of plain vanilla ETFs with fund expenses so low that you wonder if Lyxor still employs any humans.

£10,000 in a Lyxor UK index tracker now only costs you £4 a year to own, at the headline Ongoing Charge Figure (OCF) rate of 0.04%.

Compare that with the £100 a year you’d pay if you had the same money stuck in Virgin’s notoriously expensive UK tracker cum customer inertia trap.

Price war over – back up the truck?

Not so fast.

War! What is it good for? (Costs now nearly nothing…)

First let’s compare the Lyxor range on OCF versus its nearest rivals.

[Update: 6/7/2018: Note since this article was published, Lyxor tells us these ETFs have been granted UK fund reporting status. This is good news, and means this snag versus the competition is no longer applicable. Always check individual fund fact sheets with any investment to be sure.]

Here’s where Lyxor wins or ties for the no.1 spot in the main equity categories (note: bold type is just for easy reading):

Fund	UK	US	Europe	Japan	World
No. 1 or tie	Lyxor Core M’star UK ETF	Lyxor Core M’star US ETF	Lyxor Core EURO STOXX 300 ETF	Fidelity Index Japan P	Lyxor Core MSCI World ETF
OCF (%)	0.04	0.04	0.07	0.1	0.12
UK* reporting fund	No	No	Yes	N/A	No
No. 2 or tie	iShares UK Equity Index Fund D	HSBC American Index Fund C	HSBC European Index Fund C	Lyxor Core MSCI Japan ETF	Fidelity Index World P
OCF (%)	0.06	0.06	0.07	0.12	0.12
UK* reporting fund	N/A	N/A	N/A	No	N/A

*UK reporting fund: A ‘No’ in this column is a big concern if the ETF is held outside of your ISA or SIPP. Yes or N/A means there’s nothing to worry about. “M’star” = Morningstar.

And here’s where Lyxor wins in UK government bonds categories (no pesky ties):

Fund	All-Gilts	Short Gilts	Index-Linked Gilts
No. 1 or tie	Lyxor Core FTSE Actuaries UK Gilts ETF	Lyxor FTSE Actuaries UK Gilts 0-5Y ETF	Lyxor Core FTSE Actuaries UK Gilts Inflation-Linked ETF
OCF (%)	0.07	0.07	0.07
UK* reporting fund	Yes	Yes	Yes
No. 2 or tie	Vanguard UK Gilt ETF	SPDR Bloomberg Barclays 1-5 Year Gilt ETF	Vanguard UK Inflation Linked Gilt Index fund
OCF (%)	0.12	0.15	0.15
UK* reporting fund	Yes	Yes	N/A

*UK reporting fund: A ‘No’ in this column is a big concern if the ETF is held outside of your ISA or SIPP. Yes or N/A means there’s nothing to worry about.

Should you switch?

On costs, the Lyxor Core ETFs now own the joint. They’ve even cut a third off annual fund expenses in intensively competitive markets like UK and US equities.

That’s impressive.

Yet the truth is the savings are negligible if you already own a rival cheap tracker that slashes costs like Freddy Krueger slashes screaming teens.

For every £10,000 of fund you own, each 0.01% OCF reduction saves you £1 per year.

Switching to Lyxor’s UK ETF might save you £2 over the next 12 months if you already have £10,000 in an iShares UK Equity Index Fund, for example. (Assuming the latter maintains its 0.06% OCF. This example for training purposes only. Terms and Conditions apply.)

I’ve heard of the miracle of compound interest, but you’ll struggle to get many loaves and fishes for that money, even years later.

Don’t get me wrong – I’m not suddenly saying costs don’t matter!

But there comes a point where even Martin Lewis wouldn’t get out of bed for the savings.

If you’re already in a competitive tracker, consider whether switching is worth your time. Or worth the risk of being out of the market.

Even if you can switch in the blink of an eye between two ETFs then it could still take you years to make back the cost of a couple of trades, depending on how much you’ve invested.

New money doesn’t face this switching cost, of course.

But there are a couple of other stink bombs to watch out for…

Pong! UK reporting fund status

[Update 6/7/2018: Since this article was published, Lyxor tells us it has subsequently been granted UK reporting fund status as expected. This section is therefore no longer applicable and this wrinkle goes away. Always check individual fund fact sheets with any investment you make to be sure.]

The UK, US and World Lyxor ETFs do not currently have UK reporting fund status.

That’s potentially a problem if you plan to own them outside of an ISA or a SIPP – although hopefully this situation will soon be resolved.

What’s the beef?

Lyxor’s Core ETFs are based in Luxembourg.1 That makes them offshore funds.

If offshore funds do not have UK reporting fund status and they aren’t in your tax shelters (ISAs or pensions) then any capital gain you make on that fund is taxed as income rather than capital gains when you sell.

That’s usually bad for three reasons2:

• Income tax is much higher for most people than capital gains tax (CGT).
• Your tax-free £11,700 CGT annual allowance does not apply.
• You can’t use capital losses elsewhere to offset the gain.

A basic rate taxpayer would pay 20% tax instead of 10% on any capital gain over zero if they sold an un-sheltered, non-reporting fund.

Avoid that scenario like Novichok!

The reporting fund status of each Lyxor ETF is stated on its individual webpage. It’s easy to miss because they’ve used the obscure acronym ‘UKFRS’ to indicate UK Reporting Fund Status. Cheeky.

The good news is this is likely a temporary situation.

Lyxor tells us it applies for UK Reporting Fund status on all LSE listed funds as a matter of course, but that it can take some time for status to be granted. Typically three months or so.

For what its worth, it also says investors needn’t worry if they trade in the meantime, because reporting status applies historically once granted.

But we’d probably err on playing safe and waiting until status is officially granted if you’re buying outside of an ISA or SIPP.

(If you are buying the ETFs tucked safely away in a tax shelter, then “no wuckers”, as Australian bartenders enigmatically say, as then the entire matter is irrelevant.)

Nose peg! Withholding tax

You also need to watch out here for withholding tax.

Stealthy as a pickpocket, withholding tax lightens the income you receive from overseas.

For example, if you directly own US shares, then Uncle Sam docks you 30% of your dividends in withholding tax before the money makes it over the border.

Fill in the right form and you’ll only pay 15%. That’s because HMRC are next in the queue, and a double-taxation treaty exists between the US and UK to stop you being spit-roasted between two taxmen.

Funds also have to pay withholding tax if they hold foreign securities. So the overseas dividends and interest paid to you come pre-shorn of withholding tax.

You can’t escape withholding tax levied on the fund no matter how roomy your personal tax shelter.

This applies to ETFs based in Luxembourg and Ireland even though you may have heard they’re a withholding tax-free zone.

While it’s true withholding tax is not levied on dividends and interest repatriated to the UK from those territories, the reality is that funds have already paid withholding tax on income they’ve earned in the US, Japan, Australia or anywhere else they hold foreign securities.

Where’s all this leading? Well, it appears Luxembourg-based ETFs such as Lyxor’s may not enjoy the same tax treaty privileges as Ireland or UK-based funds.

For example, the US whacks Luxembourg funds for the full 30% withholding tax charge according to this KPMG research.

In contrast, most Irish (and UK) funds are able to claim back 15% withholding tax in line with their country’s double taxation treaties with the US.

Lyxor has confirmed to us that dividends on its US equity fund are paid after 30% withholding tax. The company notes that US shares aren’t typically high dividend payers anyway – especially at the smaller end of the market touched by the longer reach of the Lyxor US fund, which goes beyond the S&P 500. And there are also question marks as to how long the current withholding tax regimes in other territories will last.

So one could perhaps argue that the small tail of withholding tax shouldn’t wag the investing dog here.

Still, do the sums and you’ll see that in the case of US equities, a 15% bigger bite out of your dividends could easily overwhelm the slim 0.02% OCF advantage of the Lyxor ETF – depending on how dividend-heavy the returns from its Morningstar index turn out to be.

Buyer be aware

So the situation requires more awareness than a mindfulness course.

And you may well need a mindfulness course to heal the psychic trauma inflicted by wading through this lot.

For sure, I couldn’t be happier that funds this cheap have come to the UK market, despite my laundry list of “Ah, buts…”

It’s just that there’s more to choosing an index tracker than a waifish OCF.

We haven’t even gotten into the fact that the index of the Morningstar UK ETF tracked by Lyxor is only 81% UK. 9% is Dutch, nearly 3% Swiss and 2% US!3

More reassuring is that the Lyxor ETFs don’t do securities lending and they do fully physically replicate their indices.

Gilt-y pleasure

The case is much more straightforward for Lyxor’s UK Gilt ETFs. They cost around 50% less than their rivals and aren’t troubled by withholding tax / reporting fund doubts.

Hurrah!

And regardless of whether the equity ETFs tally with your personal situation, they’ll hopefully pressure other fund providers into following suit and taking costs even closer to zero. That way we all get to keep more cash in our pockets.

Take it steady,

The Accumulator

1. You can tell because their ISIN codes begin with LU for Luxembourg. IE = Ireland, GB = UK, FR = France. [↩]
2. Everyone’s exact tax situation is different, so we can only talk in generalities here and throughout this article. [↩]
3. This mix may in part reflect the index tracking the overseas alternatives of FTSE giants, such Royal Dutch Shell or Unilever. Either way it’s another thing to be aware of. [↩]