The death of annuities
Oscar Wilde once said “It is better to have a permanent income than to be fascinating.” It’s difficult to disagree with him. Of course, the security of a guaranteed income does give you peace of mind. The problem is that it comes at a great cost like everything else in life that is guaranteed.
Clearly Oscar Wilde was talking about annuities which give a permanent or guaranteed income. Annuities were popular in his day and were in fact still popular in the UK up until April 2015 when George Osborne, the then Chancellor of the Exchequer, introduced so called Pension Freedoms as his parting shot.
I welcomed Pension Freedoms very much because they brought in much needed pensions reforms and, well, freedom. At last, individuals were to be treated as grown ups and freed from the nanny state to manage their pensions as they felt fit. One of the changes was the abolition of the compulsory purchase of an annuity by age 75. This was a long overdue reform. The most popular alternative to annuity purchase was Income Drawdown at the time.
Prior to Pension Freedoms, it is estimated around 90% of people bought an annuity according to the FCA. Today the figure is a mere 11%. What’s more there are a number of compelling reasons why this is the case.
1. An annuity dies with you unless you have a surviving spouse who typically receives a 50% widow’s/widower’s pension.
2. Annuity rates are currently at record low levels.
3. There is no flexibility with an annuity. All of the benefits have to be taken at the same time i.e. tax-free cash and pension.
4. You have to choose your options at the outset such as widow’s/widower’s annuity, level or index-linked, guaranteed or not guaranteed.
5. If your health deteriorates later you cannot change your annuity to an enhanced or impaired life annuity.
6. No tax planning opportunities.
7. An annuity purchase is a one-off financial planning decision which is irreversible once made.
Bearing in mind the above disadvantages it is little wonder that annuities have become so unpopular.
So what are the advantages of pension annuities?
1. A guaranteed income for life.
2. An enhanced or impaired life annuity if you are already in poor health when you apply for an annuity.
3. Poor investment returns do not affect your annuity income.
4. Peace of mind.
The biggest advantage of an annuity is its guaranteed income for life. However, there is a high price to pay for that guarantee, namely a low annuity rate. Just take a look at the following examples for 65 year olds buying an annuity with £100,000. This is the annual
income their capital would buy them.
As you can see the level of annuity reduces from £4,920 a year to £2,826 a year once you add a widow’s/widower’s annuity and 3% indexation. That represents a reduction of 42.5%! What makes it even worse is what if your spouse predeceases you? That means you have locked in an option for life which you will never use at a cost of 42.5% of your income.
So the standard annuity rate 65 year olds can currently expect is between 2.83%-4.92% but guess what? The current dividend yield on the FTSE 100 Index is 4.13% in spite of a spate of dividend cuts by companies recently during the coronavirus pandemic. Furthermore, dividends overall rise virtually every year in the UK. The only two exceptions over the last 50 years were in 2008 at the time of the global financial crisis and this year in 2020 during the coronavirus pandemic. So dividends are effectively index-linked. What’s more, you get to keep your capital when you die. Therefore, it’s not surprising that 89% of people prefer not to buy an annuity with their pensions. It is little wonder that annuities have become so unpopular.*
Are there any instances where annuities can be advantageous? Yes, there are a limited number of circumstances where this may be the case. For example, if you are highly cautious, if you are single, if you have no descendants and if you don’t mind your annuity dying with you. However, these individuals are very much the exception rather than the rule.
So if you are considering your retirement options do always make sure you obtain professional advice first. You know it makes sense.
*The value of investments and the income derived from them may fall as well as rise. You may not get back what you invest. This communication is for general information only and is not intended to be individual advice. You are recommended to seek competent professional advice before taking any action. All statements concerning the tax treatment of products and their benefits are based on our understanding of current tax law and HM Revenue and Customs’ practice. Levels and bases of tax relief are subject to change.