Annuities - A Guilty Choice?
Another newsletter brings another pun filled article, but I promise to limit myself to the guilt/gilt theme this time around! My topic is annuities as they are ‘en vogue’; we anticipate news of an industry record volume of sales in 2023.
A quick introduction: an annuity is a product that offers a guaranteed level of income for a fixed term or, more commonly, for the remainder of the purchaser’s life on either a single life or joint life basis. The income can be fixed or increasing. Guarantees can be built in to ensure the income is paid out for a minimum period or a percentage of the capital is value protected in the event of early death; albeit these come at a cost of reducing the income offered. Annuitants can receive higher income offers as their age increases or if the applicant is in poor health or lifestyle choices and elects to be medically underwritten; this reflects the shorter time the income will be paid for on average. The threshold for enhanced annuities is relatively low with common conditions, for example: high blood pressure or cholesterol often leading to an uplift. Annuities are most associated with pension pots. However, Purchased Life Annuities (PLA) can be taken out with any capital and the income is taxed differently to reflect the monies are coming from capital rather than taxed as pension income.
Annuities have been unfavoured for the last 15 years as the annuity rate, the income offered for giving up capital, has been historically low. However, the below chart shows that during 2022 we saw a surge in the annuity rates being offered by providers. This meant that the income that could be secured by foregoing the same amount of capital increased significantly. The principal determinant of the annuity rates is the underlying gilt yields as these determine what level of returns the annuity providers can secure over the long term. Unsurprisingly, these annuity rate increases follow increases in the gilt yields.
Chart produced by sharing pensions.co.uk
When you combine the improved annuity rates with a difficult couple of years in investment markets, it is not surprising that more people have opted to go down the route of securing an income. However, despite the increased income opportunities and greater interest in annuities, there is still a significant resistance by many to genuinely consider it as a viable option in their planning. Over the past 10+ years the media, and to an extent the adviser community, has repeatedly delivered the message that ‘annuities are poor value for money’ and the ‘annuity market is dead.’ This may largely have been true for a decade but, as a byproduct, I believe it has created an anchoring bias in many people when considering annuities today. The Pension Freedoms in 2015 and legislation allowing pension pots to pass free of Inheritance Tax (IHT) to beneficiaries have both reinforced this bias. Since it has no longer been compulsory to purchase an annuity at age 75, the industry has evolved with Flexi Access Drawdown (FAD) becoming the more popular choice. FAD allows pension monies to remain invested and any monies not used by death can pass free of IHT to beneficiaries. Therefore, it was an easily justifiable stance to avoid annuities during the long bull run in investment markets in the previous decade when annuity rates were glued to the floor.
In addition to this anchoring bias, there may be other emotions at play in contemplating retirement options and annuities, specifically a financial ‘guilt’. The current generation to be going through the early retirement phase is the Baby Boomer generation (those born between 1946 and 1964). People in this age range are widely accepted to have lived through fortunate economic conditions; on aggregate seeing significant standards of living rises and wealth accumulation during their lives. The succeeding generations: Gen X, Millennials, Gen Z and now Gen Alpha (born after 2012) have collectively complained about the inequality, particularly in relation to the withdrawal of most Final Salary pension schemes and the relative high cost to get on the housing ladder. This may be influencing some Baby Boomers, especially if they are not too dependent on income from their pension pot. There could be some guilt in taking out an annuity, potentially depriving future generations of their inheritance akin to selling off the family silver. I make no judgement as to the validity of whether younger generations have a ‘right’ to an inheritance of a pension pot, but this observation is based upon witnessing countless conversations on the topic.
Whilst the IHT argument may be a valid reason not to annuitise, guarantees can be purchased on annuities to provide some protection. This means that where there is an income need there is really no obstacle to at least consider an annuity for a portion of the pension monies (or other non-pension monies using a PLA). It is true that in most instances an annuity is a one-off decision, so there is the argument inflation could erode the income (if high cost index linked protection is not included) or future investment returns could be higher than the annuity rate secured. However, I would argue inflation risk applies just the same to invested capital and returns from investments could equally be lower rather than higher, especially given the current high annuity rates that could be secured. Therefore, I do not believe ‘what if’ conjecture is a reason alone to dismiss annuities for at least part of the retirement solution. Indeed, if anything, annuities act as a hedge if used in conjunction with investments. Securing a base level of guaranteed income takes the pressure off investments to produce an income, especially in difficult market conditions, thereby mitigating sequencing risk and pound cost ravaging. This may mean other capital could be allocated towards IHT planning, such as gifted away or invested more aggressively for the longer term or in IHT exempt investments. Or simply it could just provide some peace of mind of the certainty of income.
Having established that annuities should be a viable consideration for many people for at least a portion of their wealth, this may be time dependent. I have already explained that gilt yields are the principal determinant of what the annuity rates are. However, what determines gilt yields is the underlying rate of interest. In short, gilt yields went up when interest rates went up during the last 18 months. Recently, we have seen interest rates frozen, and the rate of inflation has come down significantly to 4.0% in December. This has led to speculation that interest rates will come down sooner rather than later, especially if the UK looks like it will go into recession. Hence, it is probable that annuity rates will come down from their current levels soon. This of course does not preclude annuities from being part of a strategy, but their relative attractiveness is likely to diminish if their rates reduce. This highlights that the world and economic environment is a moving beast so creating iron clad rules for advice is not realistic. Advice needs to adapt to this changing environment along with the changing needs of individuals; keeping the status quo should not be assumed to be the most appropriate action without review.
This article was prepared by James Martin, one of our financial planners. We always appreciate your feedback. If you have enjoyed this article or have any specific topics you would like to see addressed in future newsletters, please email us.