Are annuities really such a bad idea?

The 2014 Budget changed the entire landscape for retirement and saving. But are annuities really such a bad idea?

Most people with pension pots use their pot to buy an annuity. That annuity gives them a guaranteed income for the rest of their lives.

So you could give £100,000 to an annuity provider and you would then receive an annual income of, say, £6000 a year until you died. (The size of your annuity depends on a range of different factors including your age and health.)

You can buy a range of different annuities. These include:

Level annuities

Where the annuity payout doesn’t rise with inflation

Escalating annuities

These pay out an increasing income each year. The income could rise in line with inflation or by a fixed amount. For example, 3% a year.

Single life annuities

The income is paid out to just one person. When that person dies, the payouts stop.

Joint life annuities

The income is paid to two people, normally a couple. When one of them dies, the surviving partner will continue to receive an income.

The problem

The problem with annuities is that the payout rates have crashed over the last 15 years. That’s unless your pension pot has a guaranteed annuity rate.

There have been two main reasons for decline in payout rates. Firstly, life expectancy has grown; and secondly, gilt yields have crashed. Annuity rates are closely linked to long-term gilt yields – as yields rise, annuity rates for new retirees go up. And vice versa.

Admittedly, annuity rates did go up last year – thanks to rising gilt yields – but current rates are still at very low levels. So if you’re a 65 year old in good health with a £100,000 pot, you could get a level annuity of roughly £6,000 a year. And if you wanted an index-linked annuity, you’d get roughly £4000 a year.

These rates clearly aren’t great. You’d have got much more money if you’d bought your annuity in the nineties – roughly twice as much or more.

Annuities are also very inflexible. Once you’ve bought your annuity you’re stuck with it. There’s no going back. You also won’t benefit from any rise in the stock market.

Plus points

Annuities aren’t all bad though. The big attraction is they give you a guaranteed income that lasts for life.

What’s more, if you have any health problems when you buy the annuity, you may be able to get a bigger payout known as an ‘enhanced annuity’.

Even relatively minor conditions such as high blood pressure can boost your payout. The same is true if you’re a smoker or heavy drinker.

Get the best possible deal

If you decide that you want the security of a lifetime income, it’s essential that you get the best possible deal.

So if you have any health problems or you’re a smoker, you must tell the provider during the application process. Also make sure that you shop around and get quotes from a wide range of providers. Annuity Direct and Hargreaves Lansdown are two sites where you can compare quotes.

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Don’t forget the lump sum

Remember, you don’t have to use all of your pension pot to buy an annuity. You could take a 25% lump sum from your pot which is tax-free.

Even after you’ve taken the tax-free lump sum, you don’t have to put all of your pot towards an annuity. You could, for example, put half of the remainder into income drawdown, and use the rest for an annuity. That way, you’re getting a nice mix.

Look at this example:

Steve

Steve is about to retire. He is 66 and, he owns his house and has no mortgage

He has a pension pot of £300,000. He also has £10,000 in a savings account. He has no other assets or income apart from the state pension. His state pension is £5,880 a year.

Steve can take a £75,000 tax free lump sum from his pension pot. He then has £225,000 left. He could spend £125,000 on a level annuity which could give him a guaranteed annual income of £7,500 a year.

Then he still has £100,000 which he could put into flexible drawdown. Then he can take as much or as little as he wants from this pot. He can also decide how the drawdown pot should be invested and hopefully achieve some growth that way.

Delay your annuity

It’s also worth remembering that annuity rates may well rise over the next five years. Gilt yields look set to rise in the medium term, and if that happens, annuity rates will probably rise too.

So you could put your pot into drawdown now, with a plan to review your strategy in five years’ time. By then, annuity rates may be higher, and you may think they’re a more attractive product at that stage.

Guaranteed rates (GAR)

There’s one group of people who would almost certainly go for the annuity option. These are people who are members of a pension scheme which has a guaranteed annuity rate (GAR).

So you might find that your pension allows you to buy an annuity which pays out, say, 10% a year. If you’re lucky enough to have a guarantee like this, it might be worth taking advantage.

If you’re not sure whether you have a guaranteed annuity rate on your pension, speak to a good financial adviser who can check for you.

Different strokes

We suspect that the majority of MoneyWeek readers won’t bother with an annuity now that the rules have changed. They’ll want to go for the option that gives the most freedom.

But if you want to get a secure retirement income, annuities work for some people. Different strokes for different folks.

This guide is taken from our FREE ‘Pensions Survival Guide’, to get the full report click here.

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