The Annuity is dead - Long live the annuity

31 March 2014

Many are predicting that the Budget changes proposed will see the death of annuities; however I predict that it will instead lead to new innovative types of annuities being developed. Prices are also unlikely to decrease substantially due to tough regulations on capital reserves. Overall, this could make financial planning on retirement more complicated for pensioners, whilst putting more responsibility on them for getting it right.

After April 2015 retirees will have the additional option to draw income from their pension funds in any way they want, subject to paying income tax at the marginal rate on any withdrawals over the 25%, which can be taken tax-free. Although this offers much greater freedom, it does leave the retiree facing difficult questions. How much and when can they draw income, whilst making sure they have enough to fund their whole retirement. To make these decisions they will need to make the three following assumptions:

  • How long will I live?
  • By how much can I expect my invested funds to grow?
  • What will be the pattern of my spending as a pensioner?

How long will I live?

Experience tells us that most people underestimate how long they will live. A recent study by MGM Advantage showed that men underestimate how long they will live by five years on average and females by 10 years. A drawdown plan based upon unrealistic assumption runs a high risk of the pensioner running out of funds, leaving only state provision to support them.

Trustees funding defined benefit schemes commonly allow for average life expectancies for males in the late 80s and females in the early 90s which shows how much this has moved on.

What will be the investment growth on my funds?

Funds not taken out will remain invested how the retiree chooses. The investment growth on these funds will affect the amount of income which can be taken – the higher the return, the larger the amount of income that can be withdrawn as income. Interest rates in the UK are currently very low, meaning that retirees could be in danger of over estimating the investment growth which could be achieved. Such expected returns may not be possible with their current investments. Most likely, this will require investment in more volatile assets – and yet this will not give a guaranteed rate of return.

One can never be 100% certain about the returns of a portfolio. However, it is possible to determine a higher probability range of outcomes – something that fund managers and financial advisers can help you to calculate. Pensioners need to make sure that if they stay within that range, this will generate enough income and they won’t run out of money sooner than expected.

What will be the pattern of my spending as a pensioner?

Financial needs may vary substantially over the course of the retirement period. For instance, most pensioners will be in their best health and mobility in the early years of retirement and wish to have higher income during these years to fund leisure activities. On the other hand, more conservative pensioners may prefer to prepare for future worsening health by initially reducing spending in order to be able to fund higher costs of healthcare later in their life. Retirees will also want to consider what provision they leave for a spouse on death. It is important to decide on your retirement lifestyle in advance and assess which options are available for you to fund it.

Why annuities will need to change

In answering the questions above, one can only help but notice how personalised retirement planning should be, as health conditions, lifestyle and financial situations can vary greatly. However, until the Budget there was little you could do to tailor your retirement income to your needs, unless you had a large pension pot and/or other assets, which allowed you to be flexible with your pension arrangements by juggling with different sources of income. For the majority of people annuities have been their principal source of income, and with only a few different types of annuities on the market, there wasn’t much room for tailoring through those products. Now that the Chancellor has opened the door to new freedoms in retirement funding, annuity providers will have to develop new offerings that allow a higher degree of personalisation in order to remain a viable part of the funding mix – and to allow the annuity business to survive.

While a risk adverse person might still decide to purchase a conventional annuity with all their funds, the majority of people retiring will want to make the most of the new options available to them. To cater for them, it is expected that new annuities will come on the market to meet their needs. The types of development and adaptations that could emerge include:

  • Annuities which decrease in value – these could pay an income of say £10,000 pa in the first 10 years of retirement but then reduce to a level of £5,000 pa for the rest of the life.
  • The option to reshape the annuity during retirement to reflect a change in lifestyle or health condition.
  • Additional guarantees such as extending the period over which the income is paid regardless of whether the retiree is alive or not – this will reassure those concerned about dying shortly after securing an annuity.
  • Members securing a “safety net” level of pension by annuity and then using the new flexibility with the remaining assets.

Will the cost of annuities change as a result of the Budget?

There is no doubt that fewer annuities will be purchased going forward. From our experience we would certainly expect that any retiree with total funds of £30,000 or less would draw this amount as the alternative annuity of approximately £20 per week will look very unattractive. Larger fund holders may look for a mixed option combining drawdown and annuities as set out above, but nevertheless this will lead to a drop in the demand for annuities overall. Many people feel annuities are overpriced and expect insurers to reduce their prices significantly as demand falls. However, they need to bear in mind that insurers must comply with tough legislation on how much capital they hold for each annuity and it is expected that the prices will remain unchanged or only fall by a small percentage as a result. The insurers would also have to follow this legislation in reserving for the options included within the new types of annuities suggested above – if the cost of these options is too high then the impact on the annuity income could be seen as unacceptable to pensioners.

Summary

The Budget 2014 has given a vast amount of freedom for retirees in using their pension savings; however this is a double-edge sword as the onus will now be on pensioners to find a sustainable (if not optimal) way to ensure they are financially secure throughout their retirement. Whilst the market for conventional annuities will reduce as a result of the proposed changes from the Budget, it will only have a small impact on their price due to how insurance companies are required to reserve capital. On the positive side, we can expect a number of innovations in the annuity market to be developed, with new options for members who cannot accept the risk of drawing their funds too quickly but do not want to tie all their funds up in a conventional annuity either.

James Auty
Director james_auty@jltgroup.com 0113 203 5840