More Flexibility Needed to Meet Retirement Income Risks
September 27, 2011
As payment rates hit new lows, pension savers are being reminded exactly why they have an aversion to annuities. A 65-year-old male can now expect something north of £6,000 a year from a flat annuity purchased with a fund of £100,000. In 1990 that sum would have given him an income closer to £16,000.*
We understand this general angst. Annuities force people to make irretrievable decisions, which expose them to unacceptable levels of risk when they are probably at their most financially vulnerable and when the true benefits associated with them are least valuable. We believe a better way to deal with income in retirement is to build in more flexibility.
In investment terms, an annuity is simply a bond, with the final redemption amount replaced by a “longevity insurance policy” that will continue to pay an income until the purchaser dies. Should they live longer than the bond’s expected maturity date, then they benefit from the insurance. Should they die early, the issuer benefits.
Most annuities purchased today are level, providing no inflation protection, and single life, meaning there is no other beneficiary after the death of the purchaser. Yet, in the early stages of retirement at least, the main threats to a retiree’s “risk budget” are inflation and early death, not the possibility that they might live longer than expected.
Inflation, even at a modest level of 3%, will see the real purchasing power of a retiree’s income halve by the time the longevity insurance kicks in at nearly 90. At current inflation of 5%, the cut is 70%. And while there is only a 10% chance that a saver will die before 75, there is a two- thirds probability that they will be survived by their partner by more than 10 years.
These risks on their own would make the purchase of an annuity appear unwise. It looks even more misguided if you take into account the lost opportunity cost of investing in fixed income for 25 years or more. Indeed it is very easy to argue that—contrary to market convention—annuities are anything but the safest option for a new retiree. This is particularly the case for those with smaller pots, where the value of longevity protection is likely to be minimal compared with the benefits of retaining ownership of the fund.
The only true benefit of an annuity for someone retiring today is the relatively low adviser and management costs associated with them.
It is for these reasons that we have argued for some time that, whilst annuities make sense for older retirees of 80 and above, they don’t make sense for the vast majority of new retirees. For this group, a low-cost income drawdown approach which takes prudent investment risks is likely to be far safer.