Comment: annuities are shockingly poor value for money and there are better ways to use your pension savings, says Alan Higham
6:08PM BST 03 Sep 2014
Comment
"Let me be clear. No one ever needs to buy an annuity again." So said the Chancellor, George Osborne, in his Budget speech in March.
So, with annuity purchase optional, is there ever a reason to buy one? In my opinion the answer is no. Here are my reasons.
1. Value for money
As they stand, annuities are simply shocking value for money.
For people in good health, the best annuity offers the prospect of an annual return of less than 1pc over the 20 years of expected retirement for a 65-year-old. Locking into a 20-year fixed savings rate of 1pc is financial folly.
Anyone who can afford to take some measure of investment risk could do an awful lot better on a do-it-yourself basis.
Aviva will pay you a fixed yield of 5.5pc on its 22-year corporate bond, with your capital back at the end of the period or on earlier death. A 63-year-old man might live for another 22 years and he could buy an annuity paying 5.5pc a year for life with no capital on death. Even if you live to 100 or more, having £100,000 capital preserved is a decent return for the risk.
Aviva might default, of course, and I don’t for one minute suggest that people put all their eggs into one bond investment. But a mixture of bonds, shares and property ought to do a much better job than an annuity, especially if inflation takes off.
2. Even enhanced annuities are no better
"Enhanced" annuities pay a bigger annual income to people in poor health because insurers acknowledge that they won’t live as long. Enhancements vary between a few per cent and more than doubling the rate for the more severe conditions.
One man I helped has motor neurone disease and a very uncertain life expectancy; his specialist said three to five years when he was diagnosed two years ago.
He could have bought an enhanced annuity that pays more than double the rate for healthy people – 12.5pc rather than just under 6pc. But if he died within a few years, as was highly likely, he’d have lost more than half of his fund. We could have protected the fund by buying a guarantee that payments would continue for at least 10 years, but that reduced the rate to 8.7pc – in other words, getting back only 87pc of the capital and zero investment returns.
Adding his wife to the policy just turned the annuity into her annuity.
Unless he was an exception, like Stephen Hawking, he would be better off drawing chunks of his pension as and when needed, leaving the rest untouched.
Anyone who has less than 12 months to live – as certified by a doctor based on the balance of probabilities – can access their whole pension fund tax free.
3. There's another – better – way to get a guaranteed income
What about an annuity's "insurance value" – making sure you don’t run out of money no matter how long you live? I’m a big advocate of covering your essential expenses with secure sources of income such as the state pension, a final salary pension or an annuity.
Consider Dave, 65, who receives £6,000 from the state pension and £4,130 from a final salary scheme and has a £100,000 pension pot. Dave needs a minimum of £1,000 a month (£12,000 a year) to cover his essential outgoings, so he has a £1,870 annual shortfall in secure income.
He could spend £55,000 buying an inflation-linked annuity to cover the shortfall. He could also spend £33,000 buying a "level" annuity, which means taking some risk with inflation.
But better still he could defer his state pension for three years, spending £25,000 of his pension fund to cover that missing income and the shortfall. That way, when his state pension starts, it has been increased to the point that the missing £1,870 a year has been covered. (This method is explained in more detail here.) Why buy an annuity for £55,000 when the state will provide the same benefit for £25,000?
The small minority who should still consider an annuity
There are limits to state pension deferral: the longer you defer for, the less valuable it is, and your state pension can only be boosted so far. For people with very high essential outgoings relative to their state pension who can afford to buy an annuity despite its poor returns, I would advise doing so.
Also, if you are in very poor health and have no dependants or beneficiaries to whom you wish to leave your funds should you die at young age, again an annuity would be suitable for you.
Before the Budget, more than 90pc of people bought an annuity with their pension savings. In the future, state pension deferral terms will become less generous and people’s retirement pots will be far bigger, so I expect the annuity to return. But I think very few people making a positive choice about their retirement today would conclude that an annuity is the best option.
