The Pros and Cons of Annuities

Annuities allow retirees to receive a guaranteed income for life in exchange for a lump sum payment from your pension fund. Understanding both the potential benefits and limitations of annuities can help UK retirees decide if making them part of their retirement strategy makes sense.

 

What is an Annuity?

An annuity is a financial product issued by an insurance company that provides fixed payments to a beneficiary until death. The purchaser (annuitant) pays a lump sum upfront, which provides the capital that the insurer invests in a low-risk strategy to match ongoing annuity payments. There are several types of annuities in the UK:

 

• A standard lifetime annuity – A guaranteed income for the life of the annuitant. It can include payments to the spouse after death in exchange for a reduction in the annuity income. Any such addition reduces the annuity income.
• An enhanced / impaired life annuity– This provides a higher income for those with medical conditions which are likely to reduce lifespan and therefore the payment term.
• Fixed-term annuity– Income payments are made for a period defined at outset of between five and twenty-five years.
• Escalating annuity– Income payments increase by a predetermined amount annually and can instead be tied to inflation.
• Investment-linked annuity– Income can increase based on underlying investment performance.

 

Whilst there has been limited development in retirement income products, the key choice is still whether to opt for a guaranteed income for life (an annuity) or remain invested and draw income from that invested fund (drawdown).

A key annuity concept is that of “mortality pooling.” All annuitants pool their funds within the insurance company. The annuitants who die early fund the annuities of those who live longer.

The positive impact of mortality pooling for someone in reasonable health is as powerful a source of returns as the stock market.

So, the choice is not between low, guaranteed returns and higher, volatile returns but instead between fixed versus flexible withdrawals.

Now let us examine the potential advantages and drawbacks of this key retirement income solution:

 

The Potential Pros of Using Annuities

Annuities offer a number of benefits that may make them an appealing part of a retirement strategy:

 

A Guaranteed Income

• Provides a secured income regardless of market volatility or investment performance.
• Retirees do not need to worry about outliving their wealth.

 

Fixed Payments

• Makes financial planning and budgeting straightforward.

 

Options

• Allows a choice of monthly, quarterly, bi-annual, or annual payments.
• Can include an income for the spouse upon death.
• Escalating annuities provide a hedge against inflation.
• Payments can be guaranteed for a fixed period of years to counter premature death.
• “Value Protection” guarantees 100% return of initial capital, to support a guaranteed outcome.

 

Tax Advantages

• Only portion of payments subject to personal income tax.
• Benefits from tax-deferred annuity investment growth.
• Can draw 25% of purchase value tax-free.

 

Annuities appeal to the “safety-first” mindset and are popular with people who would rather choose certainty than accept the risk of an adverse outcome.

 

The Potential Cons of Annuities

While annuities provide income security, they do come with drawbacks:

Irreversible

• Once implemented, the purchase of an annuity cannot be reversed.

 

Annuity Rates Vary

• That annuity income will be higher when the Bank of England interest rate is higher. (However, this can often offset stock market contractions).

 

Inflation Erodes Value

• “Level” payments will lose purchasing power over time.

 

Illiquidity

• Cannot benefit from a lump sum for emergencies or one-off larger purchases.

 

Annuities do not appeal to the “flexibility-first” mindset. This can also be defined as the “probability-based” approach for those who are comfortable with the idea that drawing down from an invested fund may lead to exhaustion of that fund before death.

 

Key Factors to Consider Before Buying an Annuity

Given the complex pros and cons, assess your personal situation carefully before opting for an annuity. Key points to consider include:

Lifestyle

• How much will you want to spend over the three stages of retirement? Early retirement is more active, which leads to the approach of “go-go” years followed by “go-slow” and “no-go.”

Longevity

• Will pension assets be sufficient to support the above lifestyle without introducing the potential for a future, unplanned reduction to expenditure caused by adverse fun d performance.

 

Liquidity

• Can you provide for both planned and unplanned capital expenditure, be that a holiday of a lifetime, home repairs or care fees?

 

Legacy

• Do you want to provide for your children upon death?

 

Considering Annuities as Part of Retirement Planning

Firstly, the majority of us anticipate an element of regular fixed income in retirement – the state pension.

The choice is then how to best utilise your pension to best support you in retirement. After all, is your discretionary expenditure as flexible as the name suggests? Would you be willing to reduce expenditure on hobbies after a sustained period of lower than anticipated investment performance?

As with a great many financial decisions, the choice is not a binary one of “annuity” or “drawdown.” Instead, a mix of both options, tailored to suit your personal financial position, is likely a better outcome.

At Fiducia, our multi award-winning team of Chartered Financial Advisers can structure your assets and investments to best meet your retirement planning. To have a free initial discussion with a member of our team, contact us below.