Who will still need to buy an annuity?
It s not hard to see why annuities have had a bad press. Rates are almost at an all-time low, meaning even large pension pots give meagre incomes once an annuity is bought.
Annuities have been mis-sold too and people are reluctant to hand all their pension savings to an insurer at retirement.
Despite these shortcomings, annuities are the only way to deliver a guaranteed income stream in retirement, no matter how long you live.
This is makes them very useful, if not irreplaceable, part of a middle-class retiree s financial armoury.
John Ralfe, an independent pension consultant, said: The seriously wealthy don t need to worry about annuities – there is little chance of them running out of money in retirement.
Annuity rates over the past 10 years for buyers aged 60 (dark blue), 65 (blue) and 70 (green)
Based on a single person with £100,000
Source: Hargreaves Lansdown
At the other end of the scale, annuities are of limited value to those with smaller pension funds, who will be largely reliant on state benefits.
A £10,000 pension pot for example could be used to pay off a mortgage or other debts, replace the car, or carry out essential home improvements. But as an annuity it s worth less than £50 a month, which may have a negligible impact on living standards.
This isn t the case for those with more substantial pension pots who also face the very real prospect of outliving these savings, if they are not managed correctly.
If you keep your pension fund invested your income could fall if investment returns are poor, or if you live far longer than expected. A combination of the two can seriously derail your retirement plans.
Mr Ralfe added: A lot of the problems with annuities stem from the way we think about them. Most people regard an annuity as an investment product. and as such aren t enamoured with the returns. Instead, think of it as an insurance product that pays out if you enjoy a long life.
Of course, this doesn t mean you ll want to use all your pension savings to buy an annuity. The new pension rules allows for those with reasonable pension pots to take a more flexible approach, combining annuities with drawdown options.
Billy Burrows, associate director of Key Retirement Solutions, an advisory firm, said: Prior to these changes, most people with small and middle-sized pension pots bought an annuity. Often this was because the industry was very bad at explaining what the alternatives were.
The new pension rules change this, he says. Far more people will be aware that they can cash in their pension. He says hopefully this will force many to look at their retirement options more carefully. In many ways the choice remains the same as it has always been – do you want the certainly of a annuity, or the flexibility to take cash and income from your pension when it is needed? The difference now is retirees can combine these options.
The choice allows people to mitigate some of the inherent drawbacks of annuities.
For example, people may use part of their pension to buy annuity – ensuring they have a small guaranteed income to pay basic bills – but keep the rest invested, to hopefully boost overall returns.
If the remainder of your pension is invested in share and bonds, this should help you grow your capital in retirement, and deliver a rising income in real terms. This has been one of the serious limitation of annuities. Most retirees opted for a level annuity, which pays a higher starting income, but one that does not increase year on year. This means its value is gradually eroded by inflation: those living well into their 90s, can find the value of their pension effectively halved.
A mix and match approach means you aren t handing all your money over to an insurer, and thus losing complete control of your capital. By splitting your pension fund between annuities and income drawdown you can effectively hedge your bets.
If you die in the early years of retirement, you haven t lost your entire pension; there may be surplus funds to leave to heirs. If you live longer than expected, the annuity payments mean you won t outlive your savings either.
Alternatively, some will opt to keep their money fully invested in the early years of their retirement, but buy an annuity at a later age.
This may enable some to take advantage of more favourable annuity rates. As people age, annuity rates increase, to reflect the fact this income isn t likely to be paid for as long. But retirees need to tread carefully: annuity rates have been on a downward trajectory for years, and these pension reforms are expected to exacerbate this trend.
Mr Burrows said that the fact that fewer people are buying annuities means there will be less cross subsidy occuring where those who die in the early years effectively pay for those with longer lives. This could force annuity providers to lower payouts further.
Since 2008, annuity rates have fallen by around a third (see graph, above). But John Lawson, head of policy at Aviva, points out that the main reason for this decline has been falling bond and gilt yields, which are used to price annuities. If and when interest rates rise, then there may be some recovery in annuity rates – provided there isn t any marked increase in longevity over this period.
However, it is worth noting that far more people have minor, or more serious medical problems by the time they reach their mid 70s, meaning they could benefit from an enhanced annuity rate.
Finally, one of the main problems with annuities have been the way they are sold. Whether you are buying one with part, or all of your pension fund it is essential you shop around get the most appropriate product and highest rate.
Never simply accept the rate offered by your current pension provider. And make sure that if you are on medication, have any health problems, smoke or are overweight that you tell your annuity provider – and get this reflected in the rate paid.