“Imagine a set of identical 65-year-old twins who plan to retire,” says behavioural economist Richard Thaler in the New York Times. Dave and Ron have each accumulated retirement benefits worth the same amount in dollars. But those benefits aren’t going to be paid out in the same way.
Dave will get a monthly income (an annuity) of $4,000 for the rest of his life. Ron will get a lump sum he will have to manage himself. The actuarial tables tell him he has only a 30% chance of reaching 85. If he draws down $4,000 a month, the money (including the income and the capital) will last that long.
But what if he lives longer? If he only takes $3,000 a month, the money will last until he is 100. He has to make some big choices. So who do you think is happier? ask Thaler. Nearly everyone you ask will say Dave. It’s a no-brainer.
But “here’s the rub”. People may say they prefer the certainty of an income forever, but when given the chance to swap a lump sum for an annuity on retirement, “nearly everyone says no”. Why? One reason is complication and fear.
Having to make a final decision on who to give all your money to is terrifying – which is why UK pensioners have so often gone for their default insurer rather than shopping around. Another is the concern that your heirs are getting a rotten deal. Once you’ve bought an annuity, you’ve guaranteed that they will inherit nothing from your pension (if you die before the money runs out, the insurer keeps any excess).
But mostly, the problem is that people seem to see annuities the wrong way around. Instead of seeing an annuity as a type of pooled insurance (you get paid however long you live – even if your own money has run out), retirees see it as a gamble (they have to live to a certain age before they get payback). Instead, they should perhaps see having to manage their own money (and so guess their own life expectancy) as the gamble.
Here in the UK, we have just been told that we no longer need to buy annuities with our pension savings. Come next year, we can take it all in a lump sum (subject to paying our marginal rate of income tax on 75% of it), or enter into ‘draw down’ – where we leave it in our pension funds and draw it down as we think we need it.
Given Thaler’s thoughts (in 2011 he suggested that there should be a “role for government” in selling annuities), has George Osborne done something that will make us take more risk and so make us more unhappy (uncertainty and unhappiness tend to go hand in hand)?
I think not. Why? Partly because we approve in general of financial flexibility, but also because annuities in the UK are such poor value that they make a nonsense of the figures Thaler gives above. That has long made them more of a gamble than an insurance.
Pensions expert Ros Altmann looked at it last year and concluded that on a standard deal, you’d have to “live to 90” to get any value. Not 75 or 85, but 90. Her judgement? It may not be the case in the US, but in the UK an annuity has turned into “the biggest gamble of your life”.
This doesn’t mean things won’t get better. The shock our annuity providers got last week may push them into improving their offerings (lower profit margins for them, a better deal for you). And if interest rates start to rise at the same time, old-fashioned annuities will suddenly look like the lower-risk route, and will be something we all take by choice. That day just hasn’t come yet.
What to do now
An annuity may still be the right thing for you to buy. But with the changes in the Budget (see above) a huge new piece of information has just been added into the decision-making mix, which means you should adjust your decision-making process entirely.
So if you are coming up to retirement, it probably makes sense to delay taking your pension or to enter draw down (taking your 25% tax-free cash and whatever else you need) while you wait to see what happens.
Our financial industry is nothing if not innovative – give it a few months and it’ll have invented a hybrid product that gives you income without commitment, and it’ll have come to terms with the idea that it has to make annuities better value. So why buy now?
If you have already retired and entered draw down, stick with it. There is an interim period before the new system comes in that relaxes the current rules – you can ask to have your draw-down income raised on the next anniversary of the setting up of your scheme, for example – and when the new rules come in everyone will be free to use their funds as they wish. You’re already in a good place.
Finally, those who already have annuities. If you bought yours a while ago there is nothing you can do – you signed a private contract with a private company. So stop reading the money pages for a few weeks and take solace in the certainty of your regular income. If you have bought in the last few months, however, you might want to take action.
Most firms have 30-day cooling-off periods and some firms, such as LV and MGM Advantage, have extended these to 60 days. If you are with NFU Mutual or Standard Life it is worth getting in touch too – they are promising to refund anyone who bought as far back as 19 January and 13 February respectively. Aviva has also said that it will “look at cases” of relatively recent purchases. Get in touch with all of these places, ask to cancel and then think again.