Annuities: Is their bad press deserved?

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.

Final words

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

Comments

    1. Haha. Thanks Mr Fu (is that right?) I’m in the lucky position that this is quite far away for me. So I can pretend for a good while yet I won’t have to make the tricky decision!

  1. You do not cover the giving up of my capital to the insurance company.

    Could you please explain why an annuity is preferable to drawdown which provides me with more income combined with a rising ‘pot’ which I can pass on to my children. I understand the academic points but the reality of the past 10 years annuity rates has offered very poor value imho.

    1. Hi Diy Investor. I’ll be upfront, as I mentioned in the post, I’m wasn’t being balanced. I have presented the positives but less so the negatives.

      Value / affordability is a big issue with annuities and has been for 10, perhaps even 20 years. Rates have been on a downward trajectory since the early 90s. Partly due to falling gilt yields, partly due to rising life expectancy.

      There will be many people for whom annuitising their whole or substantial part of their pension won’t be suitable. From reading your great blog for a number of years (and making lots of presumptions here!) I’d tentatively suggest an annuity is relatively speaking less suitable for you. You are of course an experienced investor, comfortable with managing your portfolio. But many people are not! In your blog from December you talked about how 30% of people (admittedly non UK) fail that simple 3 question finance test. LINK

      A second thing is that judging value is very difficult. Many people might have been saying the same things about annuities in 2000 (I’m speculating as I’m too young to know). But buying an annuity might have been a good call. For example, Early Retirement Now, calculates that a 4pc drawdown since then would leave you now with somewhere between 50 and 25pc of your initial pot in real terms! Likewise, if you think like Mr Bogle and believe that re equity returns will struggle to top 3-4pc for the foreseeable future, then an annuity might feel like a good bet right now. Link: LINK

      It all depends on the individual. In that respect, the pension flexibilities are (and have been) a very good thing. It also means, somewhat counter intuitively, that the case has improved for annuities. That’s because, rather than being the sole driver of retirement income, they can now be used more flexibly than before and in ways that work out better for a lot of people.

      On my phone so apologies for any typos. I’ll edit the comment with links to your blog and ERN later on! All the best YFG.

      [EDITED TO ADD LINKS TO DIY INVESTOR AND EARLY RETIREMENT NOW]

      1. Thanks YFG. I just think the issue of giving up a large lump sum permanently needs to be mentioned combined with the changes to legislation which enable the pension pot to be passed on to beneficiaries at a far lower potential tax take.

        I hope you can write something which balances up the merits of a drawdown approach at some point.

        1. That is a fair point, and the IHT changes to pension pots are a huge and positive change for retirees (and their families).

          And I will write about the merits of drawdown. In some respects, drawdown has also had lots of negative coverage (lambos et. al). Now I’ve put my word out there, I’ll stick to it. I’ll have a plan of it and maybe end of this week or next week I’ll write it up!

  2. Nice post! I am probably still not going to use an annuity because they all seem to be *nominal* and not inflation-adjusted. I’d remove longevity risk but introduce inflation risk. If they offered CPI-adjusted products (not just some fixed 2% adjustments, but actually tied to the CPI), I might replace some of my bond portfolio with an annuity!

    1. Hi ERN! I am of course very pleased to see you commenting 🙂

      I can’t talk for the US market, but in the UK inflation-linked annuities are readily available. The downside is that they are very costly, you could end up with up to 50% lower starting income. A large factor in this is that UK index linked gilts have large negative yields. If I was personally in the position of deciding on an annuity arrangement I’d strongly favour something inflation linked. That’s because inflation risk, if anything, is the cornerstone risk of why we invest.

  3. Thanks for this, YFIG – I really enjoyed the Monevator post so it was good to read a bit more on the topic here.

    As @diy investor (UK) has demonstrated with his own drawdown strategy, annuities aren’t the best choice in every scenario. However, I’m fine that your post isn’t balanced because it’s been so long since I’d read anything vaguely positive about annuities.

    As per my comment in Monevator, my DB pension and state pension will provide my ‘annuity’/guaranteed income from when I’m 67, enough for my ‘bottom line’. I may now consider however buying an annuity with one of my SIPPs later in life, probably primarily due to point 4 of your post, the hassle factor – I’m happy tinkering around with my spreadsheets now and tracking my investments, but with my ISA invested too, there might be a time when it’s all gets bit too much and I want the simplification of guaranteed income. It’s unlikely to be a huge sum, I’m envisaging something in the £50k region to buy the annuity which probably won’t get much but perhaps enough to cover some utility bills. How the markets do will also be a factor and also my own confidence as an amateur investor in knowing when and what to sell.

    Of course, anything could happen between now and the next 20 years of so and some other financial vehicle comes into play to change how people get their income in retirement but I wouldn’t write off annuities completely, especially as I have no children to pass my ‘fortune’ to and I can’t spend the money when I’m dead!

  4. May I invite you to write on Purchased Life Annuities i.e. annuities bought with money that isn’t within a pension pot.

    1. Hi dearieme, I saw that there was a little discussion on PLAs on Monevator. I don’t have any experience in practice on them like Mr Meldon (as I’m not an IFA) but I know about how they work etc. There isn’t much written about them in the press or on the internet – so I’ll add it to the list my list of topics! Roughly speaking, they are mostly tax-free. The income is primarily treated as a return of capital (a bit like an investment bond). There is an ‘interest’ element that is taxable based on a formula: with purchase price, annuity income, and life expectancy being the main inputs.

      They can be quite beneficial for individuals who take a PCLS (tax-free cash) but don’t want the lump sum. That’s because pensions are a tax deferral scheme, you don’t pay tax going in – but do coming out. Buying a PLA with your tax-free cash means 25% of your pension pot can be used to get a tax-free income for life. They’re also helpful because they can be used ‘joint life’. That’s especially helpful for DB members whose scheme may pay only a 50% widows’ pension.

  5. YFIG thanks for this post. Its kinda been discussed around the edges but I think where an annuity can come into its own is later in a retirement journey as an option that is always on the table to take up.

    I feel like once I am ‘in’ retirement for a while I will have a better sense as to the reality of my risk tolerance, appetite to keep actively managing my investments, and importantly what my bottom line really is. Maybe it will be the state pension (though I am likely to retire outside the UK so I wont get the CPI on that boo) when I am 70 or 80 or maybe I will feel I need more.

    You will know better than me but I also assume that taking out an annuity later in life means the rates may be better as the longevity risk lessens for the provider…?

    Overall I find it comforting to know that it is out there for me to lock in if I feel I need to.

    1. Hi. Thank you for the kind words. I think you are quite right. Having the option available is a very good thing. The option is annuitise part or all of your pension can become a more enticing offer later down the line.

      Generally speaking as you get older the annuity rate will fall – all other things being equal. However, annuity rates rise and fall over time due to changes in gilt yields, inflation and the dark magic longevity risk calculations that actuaries do to create their actuarial tables.

      As an aside, I’m sure there are good reasons for not increasing expats’ pension with inflation. But to me it does feel rather unfair. Happy for people to challenge me on that however!

      1. The whole pensions thing when you leave the UK hurts my head, particularly with the QROPS changes recently. They were brought in for the right reasons (to protect people from dodgy ans expensive transfers and minimise tax avoidance) but for people like me for example, with DC schemes in the UK and likely retirement destination Australia, they make for some complicated planning!

        On the state pension – I try to be philosophical. As you have referenced in another post its probably going to look different, whether claiming in the UK or not, for all of us with some time to go (I am 40) before it kicks in. I live in Asia and have come to really appreciate the safety nets that exist in the UK even if there is some uncertainty about their future value. When you have grown up with that, and then see that it is partially or completely absent in other countries, you count your blessings!

        OTo slightly elaborate on this point – as the child of baby boomers I feel I benefit from them both being well looked after by the legacy generosity in our country, which I know lots of younger folks feel cross about. My parents have DB pension schemes from their public sector teaching jobs, are now on the cusp of starting to claim state pension and other benefits like free travel, get free healthcare, and have a paid off house worth three times what they paid for it given property appreciation in their lifetime. This takes a huge burden off me to care for them financially. My friend in Cambodia – his mum has none of this, and its all down to him to provide for her and his younger brother for the forseeable. My friends in India – shades of the same. I know people in the UK grumble that we are paying for the previous generation, but I prefer how we do it to how they have to….

        1. Very thoughtful comment financialdragon. We tend to forget that we do have it quite good in the UK!

          Have to say though, I wasn’t very happy with the latest QROPS change. I understand why it was brought in, but I thought it was quite underhand to bring it in retrospectively.

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