There was a time when annuities were the only game in town for defined benefit scheme members and personal pension holders. On retirement, their pension fund, or the portion of it that they didn’t take as a tax-free lump sum, was automatically invested in an annuity which guaranteed them a fixed income for the rest of their lives.
That sounds almost idyllic, but there are some quite serious drawbacks. The first is that when you die the annuity dies with you in most cases. That means if you are unlucky enough to die shortly after retirement the money stays with the company that issued the annuity. Of course, there are joint products which will continue to pay a reduced rate — usually 50 per cent — to a surviving spouse or civil partner, but the rate of return is reduced as a result.
The other main downside has been the very low rate of return offered by annuity products in recent years. At the beginning of this year returns were just 3.75 per cent, meaning that an investor would have to live for 27 years — until they are 92 if they retired at 65 — just to get their money back. And half of the couple would have to live for a lot longer if they had opted for a product that paid a survivor’s pension.
However, with inflation and interest rates on the rise annuity returns have also increased. Does this mean that annuities make sense once again, particularly for investors who crave certainty?
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Not necessarily, according to AIB head of retirement planning Jim Connolly. “Back in the 1990s, an annuity rate for a 65-year-old buying a level pension was probably around 11 per cent, meaning that a €100,000 pension fund bought €11,000 in income for life,” he says. “Today the rate is around 5 per cent. There is no question that annuity rates have improved recently, however it is debatable whether they have improved sufficiently to create a compelling alternative to an approved retirement fund [ARF]. But one strategy that clients can consider is to park their fund in an ARF until such time as annuity rates make sense and postpone the decision that way.”
Chris Carlile, principal with Mercer Private Wealth, points out that the current joint annuity rate for a 65-year-old is 4.45 per cent. More attractive than it was, but still not brilliant.
“Despite these drawbacks, there are a myriad of reasons why purchasing an annuity might be the most suitable option at retirement and should be considered,” he says. “One of the recent additions to the annuity market is enhanced life annuities. This is where someone who is in poor health may be able to qualify for a higher annuity rate by completing medical questionnaires which can result in a materially higher rate than standard if their life expectancy is reduced.”
Certainty
Bank of Ireland head of pensions and investments Bernard Walsh notes wryly that this is one of the few areas of life where smoking can be to your advantage.
“What a lot of people like about an annuity is its certainty,” he adds. “If you are somebody who thinks an annuity with a 4 per cent or 5 per cent return in addition to the state pension is enough to live on, you might find it attractive.”
Carlile also points out that it may also be worth some existing retirees considering using a portion of their ARF to purchase an annuity to put a guaranteed income in place for the rest of their lives. “This could be used to provide a minimum guaranteed income while still having a portion of their retirement assets in an ARF to provide flexibility,” he says. “If interest rates continue to rise annuities will become more and more attractive and will have to be considered in more detail.”