Purchasing a lifetime annuity is perceived as being low risk,because it is secure. So long as the annuity provider (normally an insurance company) is financially strong,then one can be certain of receiving a specified level of income for the remainder of one’s life. However an annuity is not risk free. Statistically,somebody retiring today at the age of 65 can expect to live for another 20 to 25 years. It is predicted that in 30 years time life expectancy will be closer to 40 years after retirement.
One only has to look back over the last 20 to 30 years,to see how personal and financial circumstances can change. If they have changed in the past,they may well change in future.
The risk of purchasing an annuity is being locked into an income stream which does not make sufficient provision for changing circumstances.
Drawing income from the fund,overcomes the problem of having insufficient flexibility. It is possible to defer decisions about whether to make provision for inflation,or a widow(er) benefit,until there is more certainty as to whether this would be required.
Unlike an annuity where the risk of you living too long is borne by the insurance company (because it will carry on paying your income however long you live), by drawing income from the fund you are effectively taking on that risk personally. The fact that you can’t rely on other annuitants in the annuity pool to subsidise you is known in the actuarial profession as mortality drag, and to negate this drag you have to achieve at least a minimum level of growth on your fund – known as a critical yield – in order just to stand still.
All of this is perfectly achievable and in many circumstances, opting for unsecured income enables the investment risk to be balanced against the inflexibility of an annuity.
THE 3rd WAY
The so-called pension simplification rules which took effect last year introduced a number of changes to the ways in which pensions generally may now be dealt with. Pension providers have recently started to recognise some of the opportunities afforded by the new rules, and we now have – what we believe to be – a realistic alternative to the previously polarised choices.
This “middle way” takes advantage of the fact that it is now possible to buy annuities which need not last for the whole of your life. These new short-term annuities will generally last for 5 years, have a guaranteed value at the end of the term and also provide attractive “money-back” guarantees should you die before the end of the term.
We think it can be argued that there is a place for short term annuities in at least two circumstances:
First, where the natural tendency would be to purchase a lifetime annuity. By purchasing a short term annuity, one can defer decisions about inflation and widow(er) provision for a little longer, and also hope to benefit from improving annuity rates through age or health.
Secondly, where the inclination would be to opt for income drawdown, but there is still some concern about investment risk, a short term annuity may be considered for part of the pension fund in order to reduce risk and increase security.
There is no right answer to this conundrum and it is important to remember that the right solution would be to combine all three options.
There is no obligation to choose one option at the exclusion of the others and we could see circumstances where it would be most appropriate to use part of a pension fund to purchase a lifetime annuity, another part to purchase a short term annuity while leaving the balance invested to provide supplementary income as it is needed.
It is certainly the case that the new pension simplification rules have in some cases provided a great deal more flexibility.
As Financial Planners and Wealth Managers, we are ideally placed to work out the best combination of the various options. These notes have scratched the surface of what can be a complex area. If there is any aspect which is of interest please do not hesitate to get in touch.
If you would like to know more about how we as Financial Advisers can help you with your Pensions and overall Retirement Planning then visit the Retirement Planning section of our website: Retirement Planning or send us email at: firstname.lastname@example.org