Annuities right now are like a once-popular movie star whose box office appeal is fading. Their popularity has fallen thanks to a combination of more attractive rivals (approved retirement funds) and changing market trends (low interest rates). But just as Hollywood loves a comeback, some financial advisers believe annuities still have a role to play.
At its simplest, an annuity essentially involves handing over accumulated pension capital to an insurance company on retirement, in return for an annual income. The insurance company pays this amount either to the recipient or to them and their spouse. Part of the appeal of an annuity is that it’s a one-time decision. After a person chooses their annuity, they don’t need any more investment advice and they won’t need to watch the performance of the fund.
Pensions advisers have identified a specific audience who might prefer an annuity when planning for their retirement. These people tend not to make investments that carry higher risk, which ARFs do by nature. Such people prefer the security of a steady, guaranteed income at a time in their lives when they would prefer to think about other things, rather than stressing over investments that could fall or rise in value.
“When you have an annuity, one of the advantages you have is certainty in terms of knowing precisely what income you’re going to be generating. That’s an issue for some people. An annuity might work if somebody doesn’t have family that they want to leave a capital sum to, or they might not like a variable income that is based on the performance of stock markets. That’s generally the comparison that advisers make,” says Joe Hanrahan, head of retirement planning at Investec.
Someone with a pension of €750,000 at retirement age might agree with an insurance company to receive €25,000 a year. In simple terms, someone retiring at the age of 65 could choose a level pension with a guaranteed sum that lasts for close to 30 years. At a time when people are living longer, that’s an attraction of annuities compared to ARFs which are subject to “bomb-out risk”, where the investor outlives their retirement fund.
Living longer
So why aren’t more people flocking to this guaranteed income stream for their retirement years? It’s because annuities are backed by Government bonds, and bond yields have been very low for some time. On top of that, insurance companies are factoring in the trend of people living longer. “When you look at the cost of buying an annuity, someone might need to live into their 90s to get their original capital return,” says Trevor Booth, head of financial planning at Mercer.
The low annuity rates have made the cost of such a pension very high. “It’s a function of long-term interest rates. They will most likely normalise in time. For those people that would like to get an approved retirement fund, there’s nothing to stop you buying an annuity down the line, but you’re taking on the risk that you’re hoping rates will go up,” says Richard Kearney, associate director with Davy.
There are options to have the annuity’s pension income increase regularly, and this would take care of any increases in the cost of living over time. But just as with the part-pension payouts, there’s a financial trade-off for choosing this type of escalating annuity. “Depending on the type of annuity you take out, if it’s not inflation-protected, the original annuity may fall victim to rigours of inflation. But adding that protection increases the cost of the annuity and your income diminishes. All the extra bells and whistles cost money,” says Hanrahan.
Although some people like the unchanging certainty of an annuity, its ‘set-and-forget’ model comes with a downside. The rate is fixed on the day of purchase, so if annuity rates subsequently rise from their current low level, someone who took out an annuity during this decade wouldn’t see any benefit in years to come.
Biggest risk
The biggest risk of all with an annuity is early mortality. Simply put, an annuity dies with its holder. Although a person might have been in good health until retirement, if they were to pass away early, the insurance company would keep the remainder of their money. Annuity holders can set up a part-pension to any dependents in the event of the holder’s death, but this option too comes at a price.
Once the holder agrees the terms of the annuity with the insurance company, it’s not possible to change the annual amount. That leaves no room to manoeuvre in the event of a sudden change in circumstances, like a serious illness. “If somebody has a health issue, that’s certainly part of the decision-making process for whether they go for an annuity or an ARF,” says Hanrahan.
Although there has been a fall-off in the number of people choosing an annuity in recent years, Mercer’s Trevor Booth says there is still an appetite for them. Some of this demand might be coming from an anomaly in the pension rules. If someone takes more than 25 per cent of their pension fund as a lump sum, then they have to annuitise the balance. “Annuities may be expensive at the moment, but for some people, they do fit a need,” he says.
Booth advises lining up investment choices with the preferred pension option in the run-up to retirement age. “If it’s your intention to use an annuity at retirement, you should be holding a large portion of your fund in Government bonds, which tend to move in line with annuity rates,” he says.