Are Annuities Always The Worst Option?

Road sign which says 'Retirement ahead'

The sweeping reform of pensions in last week’s UK budget has put the much-maligned pension annuity back in the headlines. With annuities no longer compulsory in the UK, some newspapers began writing obituaries for the centuries-old annuity and one specialist annuity provider saw its shares drop 55% on budget day. This ignited a wider political debate about the pros and cons of a ‘nanny state’, with the UK Pensions minister saying he wouldn’t worry if those once annuity-destined savings were now spent on a Lamborghini!

So, what is a retirement annuity? An annuity is a pension product where the retiree buys an income for life in return for a once-off upfront payment.

Here in Ireland, an annuity is not necessarily compulsory. Many of us will have the option to retain pension funds in an Approved Retirement Fund (ARF) if we have a guaranteed annual income of at least €12,700 or if we put €63,500 into an Approved Minimum Retirement Fund (AMRF), from which we cannot draw funds until we are 75.

The drawbacks of an annuity are that:

1. Once you take an annuity, you lock in a rate of income for life. There’s no going back. 

2. You have exchanged your pension pot for an income, based on your life expectancy. If you live longer than expected, you’ve got a good deal. If not, the insurance company is the ‘winner’.

3. You no longer own your pension pot, just a stream of income which ends when you die – there is nothing left to pass on.

4. Your income is based on prevailing long term interest rates, which at the moment are around 300-year lows. Right now a pension pot of €100k will buy you an annual €4.5k (approx.) payment for life – twenty years ago you could have got more than twice this.

Compared to an annuity, the advantages of the ARF route are clear.

1. You retain ownership of your pension pot – which is passed to your spouse / children /estate when you die. You are not gambling on your own life expectancy.

2. You control investment decisions and continue to benefit from market returns and tax free roll-up.

3. You also control income decisions, subject to certain conditions.

4. You retain the option to buy an annuity later, which will naturally pay a higher income as your life expectancy declines.

So, coming back to the headline, are annuities always the worst option? Despite everything I’ve said so far, no, not always. I believe we should not mourn the death of the annuity just yet. True, rates are at historical lows but they are creeping back up again. Also, we must judge the annuity ‘return’ against future market returns (which of course we don’t know), not against historical market returns. We may look back in 20 years’ time and say 5% annuities were actually a decent return versus a balanced fund ARF. Those who mismanage their ARF funds due to poor investment decisions or a flawed income strategy will certainly regret not taking an annuity. And for many, the ARF option is effectively (because of their smaller pension pots) the less attractive AMRF option.

Ultimately, it’s all about horses for courses. For those of you that are comfortable with market risk and have significant resources, the ARF advantages over an annuity are significant, but I would recommend that you retain an advisor to plan your income flows and to manage your investment strategy.

For those of you who value the certainty and simplicity of a guaranteed income above all else, an annuity is the product for you. However, you should talk to a financial advisor when you are about to retire, as shopping around for the best annuity deal can make a big difference to your future income. You will also need to be aware of annuity options such as joint-life, guarantees and index-linking, how they affect your future income and how suitable they are to your circumstances.

And if you don’t want to totally gamble on either your life expectancy (annuity) or on future market returns (ARF), you can ask your advisor to provide you with a pension pot combination of annuity and ARF, perhaps including a delayed annuity purchase if suitable. One way or another, I strongly recommend you take independent financial advice at this juncture of your life.