Annuities: Is buying one a good or bad idea?

A range of flexible new products makes that pension question easier to answer, says Ceri Jones.

For most of us, the idea of a secure, regular income in retirement is a highly attractive one. However, buying an annuity, which is the only way to achieve a guaranteed income if you don't have a final salary scheme, has had a bad press.

Although annuity rates have been improving, they are still low historically speaking, having been ground down by the Bank of England's policies in the wake of the 2008 financial crisis. Moreover, consumers often fail to shop around to secure the best deal; this makes a huge difference to the income paid for those with ill health or unhealthy lifestyles, and is madness given that the cost of advice can be deducted from an annuity contract.

Around 11 million pension plan members across 5,900 funded final salary schemes have a pension that will provide a guaranteed level of income, but this fortunate group is dwindling, particularly in the private sector.

Twisted thinking

Research conducted by an adviser group asked consumers what was more appealing in retirement: a guaranteed income for life, or a pension where the value and the income generated vary from year to year but where returns over the longer term are potentially higher. Some 79% of those surveyed opted for a guaranteed income for life. In the same survey, however, only 10% said they actually plan to purchase an annuity, with income drawdown three times more popular.

"The vast majority of people want an annuity; they just don't know it," says one commentator.

"While people like the concept of an annuity – specifically, its certainty – the 'A' word has become toxic in the minds of many investors."

Since George Osborne's overhaul of pensions in 2014, the number choosing to buy an annuity when they retire has fallen by 75%, and the number of annuity providers has fallen to just six or seven. "Sales of annuities hit their lowest point this century in the last quarter of 2016, with just 17,000 purchased – a decline of more than 80% on the same quarter three years previously."

In the face of such antipathy, LV=, Prudential, Standard Life and others have pulled out of the open annuity market, leaving Aviva, Canada Life, Hodge Lifetime, Just, Legal & General, Retirement Advantage and Scottish Widows as the main players.

The good news is that bond yields have started to rise again, albeit from a very low base. Currently, a £100,000 pension pot buys a 65-year-old level income of £4,770 a year, 15% more than two years ago. Yields should continue to improve as the bank base rate edges higher.

In theory, there should be demand for some of the more inventive types of annuity, such as deferred annuities, where monthly income is paid out only after a pre-determined period, and guaranteed annuities, which protect the policyholder from the risk of losing too much on their premature death by guaranteeing to pay out for a certain number of years, no matter what.

One of the drawbacks of traditional annuities was that they were designed to die with you, says Andrew Tully, pensions technical director at Retirement Advantage.

He says:

"Since the pension freedoms, that has all changed. Now people can opt for income guarantees of up to 30 years or 100% money-back protection, so customers can be sure that their families will get their pension money."

Deferment dilemma

Deferred annuities have become a talking point in the pension debate. To recap, these allow an annuity policyholder to time their monthly income to start when they reach a particular age, ideally just as their drawdown pot is running dry and the security of an ongoing regular income becomes paramount. Furthermore, at this point many pension investors will no longer want the hassle of managing their own investments. There has been some take-up of deferred annuities in the US and Australia, but the obvious dampener is that the premium must be paid upfront, while investors can only hope that the annuity payouts will match their needs down the line.

Fixed-term annuities that pay out for a predetermined number of years should be useful in several scenarios – you stop work but need an income prior to state pension age, for example. Equally, if you expect to receive an inheritance at some point, you might want a secure income in the meantime. You may wish to phase in retirement and use the annuity income to offset the reduction in your working hours over those months. Fixed-term annuities might also be desirable for people in poor health, who expect to recover but are in immediate need of income to tide them over.

Hybrid solution

Most of the excitement, however, is focused on arrangements that combine an annuity with a drawdown plan in a single tax wrapper. The central idea is that the annuity should cover core living costs, while keeping the remaining pension assets invested in a diversified drawdown portfolio should allow the fund to continue to grow over what may be a multi-decade retirement.

Any income generated by the drawdown fund could, for example, be used to help meet ad hoc expenses such as holidays and then to buy nursing care, or could be left tax-efficiently to one's family. Such an arrangement allows the retiree "to stagger decision-making to avoid locking in too soon to inflexible products", says David Stevens, life advice director at LV=.

The best-known hybrid plan is the Retirement Account from Retirement Advantage, now part of Canada Life. Mergers in the market have taken out players such as Partnership, which was assimilated by Retirement Advantage. Meanwhile, poor take-up has already prompted Metlife and Aegon, which launched plans in response to the new freedoms, to exit the market. However, Scottish Widows and Royal London are still considering offerings in this space.

The attraction of a hybrid arrangement comprised of separate retirement solutions in a single tax wrapper is that any income accumulates in a single cash account and can be retained in cash, reinvested or taken as benefits through flexi-access drawdown. This gives you complete control over the timing of any payments. Even secured income from an annuity can be reinvested in the drawdown account, to be taken at a later date.

Being able to reinvest income before it is distributed allows you to plan for income tax very precisely: by using up your standard-rate allowance in full to avoid paying any tax at a higher rate, for example.

The fact that a hybrid plan is written under pension drawdown rules also means that on your death any annuity guarantees and value protection proceeds are paid into the drawdown account of the beneficiary of your estate, together with the remaining drawdown fund, and can be taken by the beneficiary over a number of years to minimise the tax payable.

Conversely, with a standalone annuity, any lump sum must be paid out immediately and is subject to the relevant marginal rate of tax.

The hybrid's single pension wrapper structure also has the attraction of simplicity, with just one illustration, one application form, one annual statement and one P60.

An arrangement offered by a life insurance company will also carry greater levels of compensation than a scheme under the client money regime of an annuity brokerage firm.  

While the logic for these plans is compelling, the downside is their costs. It is estimated that the management of a hydrid scheme adds 1-1.5% to an underlying product's ordinary cost structure. Moreover, hybrid plans are complicated for advisers to explain. Until annuity rates bounce back more strongly, new launches are unlikely.

Darius McDermott, managing director at Chelsea Financial Services, says: "While there is no guaranteed income when you invest outside of an annuity, the potential rewards are better. If a portfolio is well-diversified, while the underlying capital will rise and fall, the fluctuation in income should be minimal, especially if you invest in a fund that has a good track record of growing its dividend. There may be some more planning required to make sure your portfolio distributes a regular income, but this can be done fairly easily.

"If and when interest rates rise to a more normal level, annuities may become more attractive again, but for now, I'd look elsewhere."

Suggested income alternatives to annuities

Most advisers prefer equity income funds for drawdown and believe these will beat annuity returns over the long term.

McDermott says:

"We like Rathbone Income, which has increased its dividend in 24 of the past 25 years, and M&G Global Dividend. When it comes to bonds, we avoid funds that take too much risk chasing a higher yield now. We prefer more diversi­fied options such as Jupiter Strategic Bond. We also like VT Infrastructure Income, as infrastructure assets are usually inflation-linked, and TM Home Investor, which invests in physical residential property."

Full performance can be found on the company or index summary page on the interactive investor website. Simply click on the company's or index name highlighted in the article.