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Case for annuities
What is an annuity and what makes them unique?
A lifetime annuity is a policy that converts a capital sum into a series of future income payments for as long as the policyholder is alive.
Most annuities pay a guaranteed income for life and have the following characteristics:
- They pay an income for the rest of the policyholder’s life, no matter how long that is
- They are based on the principle of ‘mortality cross subsidy’
- Enhanced rates are available for those in poor health
- On death, payments stop unless a joint life annuity, a guaranteed payment period or value protection option has been selected
- On death, payments stop unless a joint life annuity, a guaranteed payment period or value protection option has been selected
In order to meet the income for life promise, annuities are based on the concept of mortality cross subsidy.
Mortality cross subsidy is unique to annuities and clearly favours those in good health who may live longer than expected at the expense of those who die early. To overcome this problem some insurance companies provided enhanced annuities. Enhanced annuities pay a higher income for those who have a medical condition that may reduce their normal life expectancy.
Mortality cross subsidy
Actuaries calculate annuity rates assuming people will live until their normal life expectancy. Some policyholders will die before they are expected to and some will live longer than expected. Insurance companies make a profit from those dying early and a loss from those living longer, but they use savings from the early deaths to subsidise the income paid to those who live longer than expected.
This is mortality cross subsidy.
A basic annuity will stop making payments when the policyholder dies. In order to protect against the risk of losing out if the annuitant dies before getting a good return on the investment, or losing out to inflation, annuities have a number of options. These include; joint life, guaranteed income periods, value protection and escalation.
All annuity payments are taxed as income at the annuitant’s marginal rate. If the policyholder dies before age 75 any income or value protection payments paid to beneficiaries will be tax free. If the policyholder dies after age 75 any income paid to beneficiaries will be taxed at recipient’s marginal rate..
Other types of annuities
Most annuities are purchased with the money saved up in a pension plan and understandably these are called pension annuities, but annuities can also be purchased with private savings and these are called purchased life annuities (PLAs).
There are very few PLAs sold.
Although the vast majority of annuities purchased are the guaranteed type, there are also annuities where the future payments will increase or decrease in line with investment performance. These are called with-profit or investment-linked annuities.
Annuities are very safe – there is no investment risk
In the UK annuity policies are issued by life assurance companies which are regulated by the Financial Conduct Authority (FCA) and the Prudential Regulation Authority (PRA). This means that annuities are highly regulated and insurance companies must ensure that they invest their annuity funds in safe funds so they can always meet their future annuity payments. Therefore annuities are one of the few financial products that provide an income guarantee.
Conventional annuities are known as “non-profit” policies. This means that payments are guaranteed as long as the company is solvent because there is no investment risk.
If an insurance company were to be declared insolvent and was unable to pay annuity payments, policyholders are protected by The Financial Services Compensation Scheme (FSCS). The amount of compensation is 100% of the total value of the annuity.
Policyholder protection is triggered if an authorised insurer is unable, or likely to be unable, to meet claims against it, for example if it has been placed in provisional liquidation. However, if you have an investment linked annuity e.g. with-profits, unit linked or flexible annuity, the payments are not guaranteed in the same way.
The case for annuities
This can be made very simply; they are the only policy that can pay a high level of guaranteed income for life. In this sense an annuity is a pension, and in the rush to give people more choice it is easy to lose sight of why people save for a pension in the first place.
A more sophisticated case can be made because annuities meet the needs and objectives of people who want to make sure that they will have a regular income for the rest of their life with the peace of mind and security that they will never run out of income.
In order to argue the case for annuities I will consider the following:
- The advantages of annuitisation
- They provide insurance against outliving income
- They are the only policy that can pay a high level of guaranteed income for life, especially for those with a medical condition*
- They meet the retirement objectives of many retired people
The advantages of annuitisation
Economists, especially those in the US, have been interested in the concept of annuitisation (the process of converting a lump sum into income for life) for a long time and have argued that those who want to find the best way to stretch their income over their lifetime should purchase an annuity.
Ever since the US economist Menahem Yaari wrote about the life-cycle of a consumer with an unknown date of death but with the need to maximise income, annuities have played a central role in economic theory. Yaari showed how a consumer who did not need or want to leave money to the family, but wanted to get the maximum utility from their income, should annuitise their retirement savings.
If there were no annuities, people of pension age would be faced with two dilemmas when it came to taking an income from their pension pots; how much income to take and where to invest their money.
Insurance against outliving income most people under estimate how long they will live
'In the long run we are all dead' said the famous economist John Maynard Keynes, but how long is the ‘long run’?
The short answer is that it is often much longer than people think because many grossly underestimating their life expectancy.
It is generally acknowledged that many people of pension age underestimate how long they will live by between 5 to 10 years. This may have serious consequences for those trying to organise their own retirement income plans because it increases the risk of running out of income in later life.
As we will see later, one of the reasons some people do not like annuities is that they worry that if they die (and their partner if it is a joint life annuity) soon after taking out an annuity, the capital is gone and there is nothing to pass on to the rest of the family.
However, the advantage of an annuity is that if someone lives well beyond their normal life expectancy, they will not outlive their income.
The annuity paradox
Academic researchers, mainly in the US, use this term when they try and answer one of the most important questions in retirement income planning: Why, if annuities provide the optimum income payments for someone who wants to maximise their lifetime income without taking risk and ensures they do not outlive their income, do many people favour higher risk drawdown options? The answer to this riddle is twofold. First, many people are reluctant to make irrevocable decisions, and secondly there is a reluctance to choose an option that does not pay a lump sum to their heirs.
3: A hig h leve l of guara nteed inco me for life, especia lly for those wit h a medica l co nditio n
A high level of guaranteed income for life, especially for those with amedical condition
How high is a high income? The answer is higher enough to be more than on offer from other investments, but low enough to ensure that it can be guaranteed for life. At the time of writing, the annuity income for a 65 year old investing £100,000 in a single life policy was just over £5,500 per annum gross (see table page 5). Put another away, it represents a return of 5.5% guaranteed. Those with a keen eye for figures will spot that the reason why the return is so high is because annuity payments comprise part repayment of the original capital. Therefore it is not a like for like comparison with the income from an ISA or savings account. Never the less, there is no alternative that guarantees as high an income guaranteed for life.
Higher income for those in poor health
As we have seen, annuities are based on the principle of mortality cross subsidy and while this is good for those in good health who stand a good chance of beating the bet with the actuaries, they may not be such a good bet for those in poor health. To solve this problem, insurance companies offer enhanced annuities which pay out a higher income for those in poor health.
Those who smoke, take prescription medication or have been in hospital recently may be able to qualify for an enhanced annuity.
The table below compares the annuity income for a range of medical conditions.
You do not have to be ill to qualify for an enhanced annuity. Many of those living with common medical conditions such as diabetes can qualify for an enhanced annuity.
You can get a higher income elsewhere but it may not be sustainable
The annuity critics are quick to point out the advantages of the alternatives such as pension drawdown or fixed term income plans where it is possible to take a higher income. This misses the point that an annuity pays a guaranteed income for life whereas the other polices (except unit-linked guarantees) do not guarantee an income for life and consequently the income could be less in the future.
Financial advisers point out the importance of ‘sustainable income’; i.e not only avoiding running out of income but ensuring that a certain level is maintained. An annuity is the only policy that ensures that a given level of income is sustainable. This means an enhanced annuity is still the best way for those in poor health to maximise and sustain their income for the rest of their life.
Strictly speaking, a sustainable income should increase in line with living expenses and an inflation-linked annuity does exactly that.
An essential part of retirement income planning is arranging an individual’s financial affairs to meet their longer term objectives. However many people have difficulty in setting out their objectives and there are normally two reasons for this.
First of all is the tension between short term needs and requirements and longer term aspirations. For many people the short term need might be to have as much income as possible whereas the longer term aspiration might be to have an income that will help them maintain a certain standard of living with peace of mind and security. Secondly, behavioural finance shows that most people value more money now as opposed to more money in the future.
Although everybody is different, everybody needs sufficient income every month in order to meet their everyday expenditure and maintain their standard of living. Therefore one of the most important retirement income planning questions is “Where will this income come from, both now and in the future”?
Many people recognise the importance of having enough income throughout their retirement but often struggle to express exactly what their retirement income objectives are. For most people, income requirements may include:
- The need for a high level of income
- Guaranteed to be paid for the rest of their life
- To continue for their spouse, partner or dependents if they die first
- Not taking undue risk
In addition people will often express the need for flexibility as well as the need for guaranteed income. However flexibility and certainty are opposite sides of the coin. In most cases the best way to get certainty is with an annuity and the best way to get flexibility is probably through drawdown.
Why we should take annuities more seriously
We should not just take my word for this; after all I could be accused of being biased! Consider the following extract taken from a paper entitled 'Annuitisation; it shouldn’t be a secret' published by the National Association of Variable Annuities (NAVA) in the US over 15 years ago. I remember every word because it made such an impact on me and I have used it in a number of presentations.
In this paper the NAVA put forward some powerful arguments why people should take lifetime annuities more seriously and made the following observations about the concerns and needs of many older investors:
- Concern for lifetime income and risk of outliving their financial asset
- A strong desire to preserve one’s standard of living in the long-term
- A desire for professional asset management
- The need of many older individuals for simplicity and structure in their financial affairs
- Coming to grips with their own mortality and expressing concern about the desire or ability of a surviving spouse to manage money in the event of their own death
The paper went on to give many reasons why investors in the US don't take annuities more seriously:
- Benefits of annuitisation are not sufficiently emphasised
- Desire for flexibility, control and death benefits
- The mistaken belief that the same goals can be achieved by a systematic withdrawal from a mutual fund (drawdown fund)
When we look at drawdown we will see that as people get older the need for income security becomes more important. This is a time when most people should be taking less risk rather than more so the case for annuities is even stronger at certain ages. In the section on the alternatives to annuities we will also explore what is meant by the ‘mistaken belief’ that drawdown is better than an annuity.
In defence of annuities
Annuities are not without their critics. The three most cited criticisms are:
- Annuities pay a low rate of income and are poor value for money
- The income stops when the policyholder dies
- There are better ways to convert a pension pot into income e.g. drawdown or fixed income plans
Nobody has been so eloquent with their criticism as Lord Grantley speaking in the House of Lords in October 1997 when he said “In my view, there are two overwhelming reasons why people should not invest in annuities under any circumstances. The first is that investing in annuities is contrary to the interests of a family. Annuities are virtually unique among all forms of investment in that they are worth nothing when the investor dies. The second reason is simply that annuities are a lousy form of investment.”
Other people criticise annuities in less eloquent tones. I'll address each of these criticisms in this section, to see if they stand up to scrutiny.
Annuities pay a low income rate and are poor value
It has been said that we live in a world where many people know the price of a lot of things but they don’t know the value. Annuities are a case in point. It is true that the income from annuities is close to the lowest levels in living memory but just because annuity rates are low it does not mean that annuities are bad value.
Annuity rates are low because fixed interest yields are low. The chart below plots the income from annuities and long dated gilt yields since 1990.
It has been said that we live in a world where many people know the price of a lot of things but they don’t know the value. Annuities are a case in point. It is true that the income from annuities is close to the lowest levels in living memory but just because annuity rates are low it does not mean that annuities are bad value. Annuity rates are low because fixed interest yields are low. The chart below plots the income from annuities and long dated gilt yields since 1990.
This chart show that annuity rates move in parallel with gilt yields and that the relationship between the yield and rates has remained constant. Therefore the problem of low annuity rates is not the fault of the annuity concept; it is the result of low interest rates and yields.
I too have criticised annuities in the past for paying low rates. I was making the point that investment linked annuities can overcome some of the problems associated with low interest rates. However for those who do not want to take any investment risk, guaranteed annuities are a hard act to beat, as I will demonstrate on page 13.
Annuities do provide value for money
There are two ways of addressing the value for money question; by using actuarial techniques and by using simple logic.
I am not an actuary, and even if I was one, few of the readers would understand actuarial speak anyway so after looking at the technical analysis I will use some simple logic to demonstrate that annuities are good value.
There is a significant amount of academic research that has used technical analysis to show that annuities are good value. For instance, the Financial Conduct Authority (FCA) published a paper in December 2014 ‘The value for money of annuities and other retirement income strategies in the UK’ and concluded that annuities purchased on the open market provide reasonably good value for money because consumers get the vast majority of their premium returned to them in income.
Jonquil Lowe of the True Potential Centre for the Public Understanding of Finance at The Open University Business School published a paper in July 2014 showing that many lifetime annuities offer fair value for money.
There is a much easier way of showing that annuities are good value for money. Think of an annuity as being like a mortgage in reverse. When you purchase an annuity the insurance company will pay you back your capital and interest over the life of the annuity.
With a mortgage you repay capital and interest for a fixed period of time until the loan is paid off. With an annuity there is not a fixed term because the insurance company will pay out as long as the policyholder is alive, no matter how long that is.
Let’s compare the repayments for a 23 year mortgage with an annuity for a 65 year old in good health who has a life expectancy of about 23 years.
The simple conclusion to these simple calculations is that standard annuities do repay the original capital invested with a fair rate of interest over a given period.
However, over recent years three things have happened to reduce the value for money from annuities. First, life expectancy has increased for all pensioners so insurance companies have had to spread payments over a longer period of time.
Secondly, annuitants have had less benefit from the so-called mortality cross subsidy because those with below average life expectancy have purchased enhanced annuities. Thirdly, insurance companies have had to set aside capital to bolster their capital reserves to meet new capital adequacy rules called Solvency II.
Although the income from annuities has fallen significantly, the value for money has only reduced by a relatively small amount.
The income stops when the policyholder dies
This statement is only true for a single life annuity where the policyholder dies without having the benefit of a guaranteed income period or value protection. In practice very few people purchase an annuity without some type of safeguard against early death.
When advice is given, most people who are married or who have a financially dependent partner purchase a joint life annuity where the income continues to the spouse or partner if the policyholder dies first.
There are three ways in which someone can guard against the risk of dying soon after taking out an annuity:
- Guaranteed income period
- Joint life option
- Value protection
The income paid to beneficiaries from a guarantee period, value protection or the joint life option will be tax-free if the policyholder dies before age 75. After age 75 income paid to beneficiaries will be taxed at the recipient’s marginal rate.
In practice, most people who seek advice and who are married or who have a partner, purchase joint life annuities so income is paid as long as one of them is still alive.
There are better ways to convert pension pots into income, e.g. drawdown or fixed income plans
The only alternative to an annuity is a form of drawdown, and there are a number of different types of drawdown including:
- Flexi-access drawdown
- Uncrystallised funds pension lump sum (UFPLS)
- Fixed term income plans
- Guaranteed drawdown (unit-linked guarantees)
- Phased retirement
Just to confuse matters some polices describe themselves as being annuities when they are not annuities at all, for example fixed term annuities and variable annuities.
All drawdown policies (except unit-linked guarantees) have one thing in common and that is they don’t have an income for life guarantee. This means that it is possible to run out of income sometime in the future if investment returns are lower than expected or the investor lives longer than expected.
There are three main advantages to drawdown, compared with purchasing an annuity and these are:
- Income flexibility
- Control over investments
- Choice of death benefits
However as with all advantages, they are also disadvantages. Before anybody considers giving up the annuity guarantee of an income for life for the flexibility of drawdown they need to be aware of, and understand the importance of investment risk and mortality drag.
At first sight this might seem straightforward because everybody knows that if you invest in the stock market the value of shares can go up or down, but in the longer run there tend to be more ups than downs.
Whilst this might be the case for those savings up for a pension, it is not necessarily the case for those taking income out of an investment. Investing during retirement is different to investing before retirement because of what is known as the ‘sequence of returns risk’. Put simply, if the investment returns are low or negative in the early years of a drawdown plan it will make it very difficult for the drawdown plan to make up the early losses in future years and may lead to a significant reduction in capital and or income.
When drawdown was first introduced, a well-known actuary pointed out that comparing annuities with drawdown was not comparing like with like, because with annuities, policyholders benefit from mortality cross subsidy whereas with drawdown they do not.
Therefore comparing annuities with drawdown is not straightforward but it is essential to have a way of comparing them especially as many drawdown policies may not be for life and may be used to purchase an annuity at a future date.
Mortality drag – the invisible force
If an annuity purchase is deferred, the annuity payable at a future date will be higher because of the policyholder's increase in age, but an invisible force slows down this rate of increase, called mortality drag. This is described as the negative effect of missing out on mortality cross subsidy if an annuity is deferred.
The practical relevance of mortality drag is that a pension drawdown fund has to increase in value by an additional amount to compensate for the lack of mortality cross subsidy if it is to maintain its ability to buy an annuity paying the same income in the future.
Let’s look at a simple example where a £100,000 fund could purchase a single life annuity for someone in good health at age 63 paying £5,158 per annum. The table below shows how much a pension drawdown fund needs to grow each year in order that an income of £5,158 can be paid each year and at the end of the year an equivalent annuity could be bought assuming no change to the underlying annuity interest rate.
* When calculating the required fund growth no charges such as annual management charges or adviser charges have have been taken into account.
The required fund growth and mortality drag increases each year and this reflects the need to compensate for mortality drag. If we repeat these calculations using enhanced annuity rates** we will see that not only is the income taken higher, but the required investment returns and mortality drag is higher.
*** Enhanced annuity for a smoker with high blood pressure, diabetes and who is obese. .
The charts below show how the figures for both standard and enhanced annuities change over a longer time period. This chart on the right is probably unique as this is probably the first time a chart showing the mortality drag for enhanced annuities has been produced.
This might sound like double Dutch, but all you need to know is that when comparing an annuity with a drawdown, is that drawdown has to compensate for the absence of mortality drag by producing consistently higher returns each year compared to the underlying rate of interest used to price the annuity. The amount of drag increases with age as the charts demonstrate.
The future for annuities
I believe there is a strong case for annuities and they will continue to play an important role in retirement income planning. Although everybody will be free to take their pension as a cash lump or regular income payments, many people will recognise the advantages of securing a guaranteed income and use some or all of their pension pot to purchase an annuity. Looking to the future, I predict four important trends: 1 New product developments and annuity buy back 2 More sophisticated use of annuities in retirement income planning 3 Increase in the personal underwriting of annuities 4 Better understanding of the behavioural aspects of decision making
If you want to make the most of pension freedoms you should start planning ahead and make sure your financial affairs are in good shape in the years running up to retirement.William Burrows
Offices in London and Northampton
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