Traditionally, an annuity was the vehicle used to provide a private pension.
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In exchange for a lump sum, it ensures a regular income for the rest of the policyholder’s life regardless of economic circumstances and the ups and downs of the stock market.
Such certainty has great appeal, particularly when the different forms of annuity are taken into account. This can vary from a single life to joint where payments continue until the second person dies.
Payments can be for the same sum indefinitely – which means the value over time will be eroded by inflation – or increased by a set percentage or to take RPI into account.
A crucial element for anyone with a family or wishing to help any beneficiaries is to ensure the policy is ‘guaranteed’, meaning that payments will continue after commencement for a set period. Otherwise the insurance company takes the full remaining value even if only one payment has been made.
Annuitants can actually find that having such a guarantee costs very little. According to independent analysis by Moneyfacts, an annuity purchased for £10,000 starting at 65 years would on average pay each year:
£435 without guarantee (ranging £384-480)
£434 guaranteed for five years (ranging £383-478)
£429 guaranteed for 10 years (ranging £381-473).
Protecting a partner after death can also form part of an annuity. Joint lives can be named with the choice of no reduction on the death of the first person or a higher sum paid throughout but with a cut of one-third for the survivor.
However, purchasing an annuity is currently more expensive than at any time in a quarter of a century. This reflects the unprecedented fall in Government bond yields.
The average annual income is now 5.5 per cent lower than at the start of the year. The present 4.1 per cent rate is the lowest since 1994 when Moneyfacts started recording. The closest such rate was 4.15 per cent in September 2016 when gilt yields fell after the Brexit referendum.
Gilt yields have decreased because investors have driven up prices owing to fears for the global economy, trade wars between the US and China, Brexit and tensions in the Middle East.
Yet pension funds continue to grow, rising 11.2 per cent since January, reversing last year’s average loss of 6.2 per cent. Many more are saving for their future for the first time as a result of auto-enrolment even though the individual sums are still low.
All employers are required to enrol staff earning over £10,000 in a workplace scheme once they reach 22 years old but are below staff pension age.
In the 1990s, a pension pot of £100,000 could have been converted into an annuity paying around £10,000 annually for a 65-year-old which today would provide only £4,350 for a single life or £3,350 for joint lives. This is without taking inflation into account.
Rising life expectancy has also reduced the rates paid. This makes it more important than ever to build up a sizeable pot before buying an annuity or one of its alternatives.
Since the introduction of pension freedoms in April 2015, annuities have been largely shunned with around 70,000 purchased each year by comparison with over 188,400 in 2014. They have been replaced with ISAs and self-invested personal pensions (SIPP), using drawdown with the latter when money was required.
With the pot for drawdown, the money remains invested in a tax-efficient environment and has the potential to benefit from investment growth. Any money that has not been withdrawn can be left to beneficiaries and, if death is before 75 years, it is tax-free.
Yet many people ignore annuities “at their peril,” say independent financial advisers Chase de Vere. Patrick Connolly, a chartered financial planner at the firm, says: “People should not gamble with the income they might need to pay day-to-day bills and living expenses. Once this guaranteed income is secure, they have a safety net in place and can consider higher risk options such as drawdown.”
If the retirement pot has grown sufficiently, the balance could well be an annuity as the base, albeit available at poor rates for non-enhanced policyholders
The right annuity choice depends on personal circumstances and requirements. It’s vital that an experienced broker is used who knows the market, notably if you quality for an ‘enhanced’ or ‘impaired’ rate owing to health.
If researching and choosing an annuity without such professional help, better terms could be missed which take into account health and/or lifestyle.
If there is a measurable effect on life expectation, life insurers will look favourably but require a medical report for confirmation.
Standard Life, for example, has been fined £30m by the Financial Conduct Authority for failures relating to non-advised annuity sales.
It offered staff amazing financial incentives but this meant some customers did not have the right information including the option to shop around. The firm has voluntarily reviewed past practice and awarded £25.3m to 15,302 customers who were misinformed.
An enhanced annuity can pay a considerably higher rate of income. Conditions that actuaries accept for enhanced payments include obvious areas like cancer, diabetes and heart disease but increasingly are paying greater sums for those with high blood pressure, asthma, high cholesterol, arthritis and obesity.
Smokers who have had the habit regularly for a minimum 10 years and light up at least 10 cigarettes a day can qualify for a better rate.
Consumer campaigner Which? found that annuity applicants who had suffered multiple heart attacks could obtain over 30 per cent more.
Do not feel under any pressure to accept an annuity from the same provider who has been used for the pension pot. Yet only around 40 per cent have opted for another source.
There are wide variations between providers. Some advisers, like Aviva, typically quote single lives on the basis that the client is married. Many rate according to postcode as far shorter lifespans are recorded in Glasgow than in London boroughs like Kensington and Chelsea.
One of the variations to consider is a with-profits policy which allows the amount of income received to be selected by going for an anticipated bonus rate. In most cases this varies between zero and four per cent in 0.25 per cent steps.
The rate selected affects the likelihood of future increases in income. On each anniversary, the bonus is declared and applied to the regular income after allowing for the rate already chosen.
If the retirement pot has grown sufficiently, a balanced approach would be to buy an annuity for basic living needs and place the remaining funds in a SIPP or ISAs which will allow the investments to grow in a tax-efficient way. This route is likely to ensure one’s lifestyle continues in retirement.
Conal Gregory is AIC Regional Journalist of the Year.