Steve Hunt goes through the different options available to clients at retirement
There are three important considerations when deciding on the right retirement income product: investment, investment and investment.
Many people perceive annuities to be poor value, but compared to what? Based on average life expectancy, a conventional guaranteed rate level annuity will return circa 3% at best - in fact, it is a little over 2%.
According to our Government actuary, a male aged 65 will live for a further 16.63 years. (see Table one).
So, for our calculations let's be generous and say that on average an annuity is for a period of 17 years. (see Table two)
Therefore, based on a slightly better than average life expectancy, returns from a level annuity would be 2.276%. For those who die before the average life expectancy, returns are even less - possibly even less than the original fund value. But what if you live to be 100? Even then the return would be 6.69% - not exactly staggering.
It does not stop there though; there are two other aspects of an annuity that are potentially devastating - irrevocability and inflation.
Once you go into an annuity, that is it; you are tied into that contract for the rest of your life.
If you opt for a joint life annuity and your partner dies, tough. If you are in good health and then contract heart disease, tough. Possibly the biggest criticism of annuities is this very point. You save money all your life, then put the fund into a fixed plan, which is fixed for 20, 30 or even 40 years plus. Even a 25 year fixed rate mortgage is not irrevocable; an annuity is - totally.
So, who remembers 1975? What a fantastic year for music: 10cc 'I'm Not in Love', Rod Stewart 'Sailing' and Queen's 'Bohemian Rhapsody'. Inflation for the year was 24.24%! Yes, 24.24%!
To be honest, the chances of these levels re-occurring in the next 25 years are, I believe, pretty high. So what would that do to a level annuity? Well, at 15% inflation, a £1,000 per month annuity in 10 years would be worth less than £250 per month - less than a quarter of its original value - and in 25 years it would be a worthless £30 a month! It is well known by economists that high inflation decimates fixed incomes, and that equates to most people who have taken out an annuity in the last five years or more. This is a huge problem waiting to happen.
So, what is the alternative? There are several, each with different advantages and disadvantages.
RPI linked annuity
This won't solve the irrevocable issue, but you could select an escalating annuity or even an RPI linked one.
To be honest though, this is a luxury most people simply cannot afford. Let's take Mr Careful for example. Mr Careful worked hard all his life amassing a fund of £100k - well above average. He retires earning £28,000 a year! He will receive a basic state pension of £4,700 p.a. and possibly an additional state pension at a generous £5,000 p.a., taking his total income to £9,700 - a drop of £18,300 p.a.
A level annuity will give him an extra £7,000 p.a. but if he chose an RPI linked annuity it would reduce to £4,400 p.a.
For many people taking their retirement incomes, an RPI linked annuity is simply not an option as they could not afford to live on the significantly reduced amount. Not to mention of course that the pay back periods are very long, depending again on inflation.
When you have finished picking yourself up from the floor, as we say to our clients, don't dismiss something because of what it is called.
Most with-profit policies have not done well, but don't tar everything with the same brush as there are a couple of with-profit annuities that have performed exceptionally well. These are REAL figures: see table three.
So, if you had taken out a with-profit annuity with Prudential in 2004, with a 4% ABR the annuity would actually have more than kept pace with inflation!
Unsecured pension/income drawdown
The 'dark knight' of retirement income, and certainly the biggest risk. Drawdown is all about two things: charges and the underlying investment. Those who were persuaded to go into drawdown in the late 90s and invested in equity based investments have more than likely had their funds decimated - twice!!
Drawdown, done correctly, can be, and is, a fantastic alternative to an annuity with significant benefits - mainly the fact that it is not irrevocable; and provided you get the 'wrapper' right regarding charges and the underlying investment, it will serve you, your partner, your children, your family pet or your favourite charity very well.
Third way products
Finally, a quick mention of third way products. For some time, there has been a void between the high risk and possible high returns of drawdown, and low risk but poor returns from annuities, and the third way providers all thought they had the answer. I am not so convinced.
That said, AIG's Living Time plan is a very good alternative to an annuity and certainly helps to solve the irrevocable issue of a standard annuity.
In conclusion, everyone's circumstances and priorities are different. What is important though is that those entering their twilight years (which may last for a quarter of their life) make an informed decision.
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