See annuities in a new light
Annuities have made a comeback. Having gone from being compulsory to being as fashionable as chintz, they’ve seen a surge in popularity since last year. But why? Some are suggesting it boils down to one word: certainty.
Think about the past 30 years. In 1987 we had the Black Monday stock market crash. Then came the 1990s recession, Black Wednesday, the Dot Com bubble, and then later in 2008 we suffered the credit crunch and the ensuing Great Recession, the after-effects of which are still being felt. Those are just the biggest crises to have hit the stock market during that period.
And yet, if you had taken out an annuity in 1986, it would have continued to pay out the same income to you every year, without a single blip. That’s the beauty of annuities – the sums involved might not be princely, but they are guaranteed. Assuming you’re still alive all these years later, your annuity is still paying out that steady amount.
Today the average retirement lasts a little under 20 years, but with rising life expectancy there are already plenty of people who are retired for 30 years or even longer. And as history shows us, three decades is a very long time in financial terms.
Is it a dinosaur? No, it’s an annuity
For a long time, annuities were the only option for the vast majority of retirees. People were effectively obliged to trade in their whole pension pot for an insurance product that would pay them a guaranteed income for life.
Then in April 2015 pension freedom was introduced, allowing people over 55 to reinvest a pension pot and take a flexible income from it (known as drawdown). The public seized on this shiny new option and the popularity of annuities nosedived. According to research by eValue, less than a third of pension pot money was being put into annuities as of April 2015, compared to more than 50 per cent being put into drawdown schemes.
However, as the graph shows, annuities didn’t stay down on the floor for very long. They saw a resurgence in popularity, even briefly overtaking drawdown before settling as the close second-favourite option. Why did this happen?
Bet you didn’t see that coming
As you can find discussed in more detail here, one of the biggest risks in drawdown is poor stock market performance. If the market does poorly, especially early on, then your drawdown fund can suffer big losses from which it is hard to recover (since you are regularly taking money out of it). For this reason, whenever there is a period of stock market volatility, the popularity of annuities tends to rise. In other words, when people are reminded of financial uncertainty, the certainty of a guaranteed income becomes a lot more appealing.
Unforeseen events can have a major impact on the stock market, and hence on any retirement plan connected to it. Examples include the Scottish independence referendum and the EU referendum – few retirees in 1990 or even 2000 would have expected either of these to take place. The debate over Brexit in particular has caused financial volatility, which may well see annuities once again becoming the most popular option for a time.
More choice = more curiosity
There may be other reasons for the resurgence of annuities. Back in the days when they were the only realistic choice, there was far less incentive for people to find out much about them. This in turn led the majority of retirees to buy an annuity offered them by their current provider, rather than shopping around for the best deal.
The choice offered by pension freedom has prompted many more people to investigate both main options in detail, often with the help of an independent financial adviser. Retirees may therefore be flocking back to annuities because they understand them better now, having been made more aware of their advantages (as well as their limitations). Rather than ‘running back to what they know’ in the face of uncertainty, it could well be a case of people making a truly informed choice for the first time.
How annuities have evolved
One of the historical disadvantages of the annuity was that it usually stopped paying out when you died, unless you were still within the guarantee period. Drawdown schemes, by contrast, mean that your remaining pension pot can be passed on tax-free to chosen beneficiaries.
The usual way to get around this annuity problem is to take out a joint life annuity, which covers both yourself and your spouse. This is more expensive, but safeguards against the loss of much of your pension savings if you die prematurely. Providers have also been working to make annuities more attractive – some now offer guarantee periods of up to 30 years, which should be enough to cover all but the longest retirements. These extended guarantee periods could potentially make joint-life annuities unnecessary, though of course they come at a cost. When considering different annuity types and guarantees, you should always talk to a financial adviser about which is the best option for you and your family.
What about long-term value?
When choosing between an annuity and drawdown, another factor to bear in mind is which could pay you more money over the longer term. This depends on many factors, the main ones being how long you live and how well the stock market performs over that time. Pensions expert Billy Burrows has demonstrated here that a drawdown scheme needs only to achieve 2 per cent growth on average to beat most annuities currently available. At face value this looks a fairly easy task, and would suggest that drawdown is the better option. However, Billy goes on to highlight the risks involved in drawdown, particularly if you draw out too much money during a period of poor performance. The bottom line is that drawdown involves speculating about what will happen over the next 20 or 30 years, whereas an annuity removes that uncertainty – for better or worse.
Guaranteed or adventurous – which type are you?
Rather than heralding the death of annuities, pension freedom has encouraged people to view them in a new light. The availability of more choice means that savers want to understand what each choice really means before making a decision. Retirees have rediscovered the advantages of annuities, as well as their obvious limitations.
Still, it would be wrong to rush back to the safety of annuities every time there is a temporary crisis in the stock market. As the past 30 years shows us, there’s no such thing as a ‘period of uncertainty’ – the markets are always uncertain, all the time. Crashes can happen at any time, as can periods of growth. Understanding the risks and opportunities of each option is essential when making your retirement plans.
A financial adviser can help you measure how much risk you are comfortable with, and so help you make your most crucial financial decisions at retirement. You can find the best adviser for you at unbiased.co.uk.