In short: No.
I had planned-out an article with reasons why I think annuities don’t deserve the bad press that they get. But, in a fantastic guest post over at Monevator, Mark Meldon, a South West UK-based IFA, makes a far more eloquent case than I could. So instead, I’m going to cheekily piggie-back off his great post. Before you read on, I would 100% recommend you read Mr Meldon’s post on the Monevator site.
Here are five reasons why annuities don’t deserve the bad press they receive.
1. Annuities provide the best method of securing a guaranteed income for life
Mr Meldon makes a compelling case in his guest post. In doing some background reading for this post, I looked at what my regulatory body (the Chartered Institute of Securities and Investments) had to say. It was pretty emphatic:
Annuities are still the best method of securing a regular guaranteed income for life
2. Annuities are (somewhat) unfairly compared to investment products
Whenever I explain how annuities work to people, I always describe them first as a kind of insurance policy. As Mr Meldon explains:
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.
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.
In effect, an annuity is an inverse life assurance policy. Instead of paying annual premiums, you receive annual payments. Instead of a lump sum payment on death, you make a lump sum payment on commencement.
Looking at annuities from this viewpoint shows us its greatest strength: it provides protection. Specifically, it provides protection against longevity risk – the risk that you outlive your money. Longevity risk is difficult to quantify. That’s why Actuaries get paid so well and have brains the size of two watermelons. And as individuals we underestimate how long we will live. Annuities also give certainty. As we saw under point 1, annuities provide the best method of securing a guaranteed income for life. In this respect, annuities do a very good job at covering two of the important factors in saving and investing: covering your risk tolerance and matching your time-horizon.
I think an element of why annuities get bad press is because the downsides of an annuity are compared to the upsides of investing. But the converse isn’t:
- In buying an annuity you sacrifice the ‘upside’ of an investment portfolio. This being where the insurer makes some of its money. But, you are protected from the ‘downside’ of the portfolio. Your income is the same even if the stock market tanks.
- Annuity rates are compared to the returns from the stock market. Whilst the annuity rate is lower than you’d get from sticking your money in an equity index fund, the annuity return per year is certain. The return from the stock market is not.
- The return over the life of the annuity is, of course, less certain. This is where people sometimes say: “I have to live X years for the annuity to pay off“. Whilst mathematically that is true, from the viewpoint of your financial goals this is less likely to be true. As I noted in my Safe Withdrawal Rate post: “For most people, [financial] success is having enough income to cover living expenses and support an adequate standard of living level.” In that respect, an annuity which covers your living expenses and provides enough income to support your standard of living is, de facto, a success.
3. We are very bad at self-control
The godfather of behavioural economics, Richard Thaler, was inspired, in part, by our lack of self-control.
The guests while waiting with cocktails for the meal, were devouring the cashews—the entire bowl half-eaten in minutes. So Thaler, worried that his guests would fill up on the salty snacks, whisked the bowl away.
He recalled that when he came back, his friends thanked him for it (and found themselves with room to enjoy a big dinner). “But then, since we were economics graduate students,” Thaler recalled, “we immediately started analyzing this. Because that’s what economists do.” Even cashews could hold the key to unlocking insights about our idiosyncratic behaviors.
Without the temptation of the nuts, he said, “We realized that a.) we were happy, and b.) we weren’t allowed to be happy, because a first principle of economics is more choices are better than fewer choices.”
I’m sure most readers manage some or all of their own investments. The urge to tinker and tweak is often irresistible. I struggle to resist the lure of the biscuit jar. An annuity takes all that off the table.
4. Annuities remove a lot of hassle
A key to life is to avoid doing things that cause unhappiness. For me, and I think a lot of people, paperwork and doing taxes will come high up their list of unpleasant things. With an annuity there is almost no paperwork once its set up. In the UK, tax is taken off at source and each year you get a P60. If you need to fill in a tax return you just bung in the number – all done. There’s no capital gains calculations, no dividend calculations, fiddling with tax sheltering, no top-slicing (*shudder*). Many readers, myself included, may enjoy managing their investments now. I’m less willing to believe I’ll be happy doing that when I’m 70/80/90+ years old. Not to mention, that as time passes by, there is no guarantee that I’ll be compos mentis.
5. There’s more to annuities than just a level annutity
There are many flavours of annuity. With different products tailored for an individual’s specific needs. To name just a few:
- Index-linked annuities: which increase in-line the payments inline with an inflation rate or other fixed percentage. These are typically the most costly option, with the starting income 30%-50% lower than a level annuity.
- Joint annuities: which continues to pay out after first death to, such as, a surviving spouse. These can also be used to pay out to children or other dependants. And you can also usually define what proportion is paid out on death. Bear in mind, that the longer the annuity is likely to pay out, and the proportion of income on death, the lower the starting income will be.
- Guaranteed annuities: these pay out for a guaranteed number of years depending on the insurer. Again, the longer the annuity will pay out, the lower the starting income will be.
- Short-term and fixed-term annuities: which pay a regular income for a specific-term. Short-term annuities can last for up to 5 years. When the term ends you can buy another annuity or invest elsewhere.
- Investment annuities: As opposed to traditionally gilt-back annuities, you can buy investment annuities which can add a potential benefit from investment growth in the stock market (or from other investments). These give the potential for a higher level of annuity, but come with some potential downside. It’s possible to add downside protection, but again this costs more.
- Enhanced annuities: which pay out higher rates for those with reduced life expectancy (e.g. smokers). If this is the case for you, think carefully about whether purchasing a life policy or leaving your pension pot for inheritance might be more beneficial.
In addition, you can buy an annuity using only part of your pension pot. This means you can mix and match an annuity with flexi-access drawdown, your other investments, or even to buy several different types of annuity. For example, you could use part of your pot to buy an annuity and provide a guaranteed income floor, whilst keeping part of your pension invested to generate long-term returns.
I appreciate that this article may feel one-sided – rest assured – it is! There are downsides to annuities. Whether they make sense for you will depend on your circumstances. I’ve not gone into detail on the downsides. It’s very easy to find a lot written about those! But I’ve touched on those downsides now and again. Principally they relate to the two other key factors of saving and investing: access and affordability. In some ways, you can mitigate issues with access by considering a short-term annuity option or using only part of your pension pot to buy an annuity. Affordability, is the elephant in the room. A number of the options (particularly index-linked annuities) may be unaffordable. It’s important to consider all the options available, but an annuity may be a very suitable option for you.
I’ll leave the final words to Mr Meldon:
Finally, annuities offer something priceless – peace of mind!
Please let me know your thoughts and comments. I’d like to hear from you!
All the best,
Young FI Guy