Pros and cons of buying an annuity

Thrugelmir

westv said:

Thrugelmir said:

westv said:

Malthusian said:

arnoldy said:

Yukster said:

If I understand this properly, buying an annuity gives me more certainty about how much pension income I will have. 

Yes, but that's no use if you are exposed to inflation where you have zero certainty!!. For example this year all people on fixed annuities are likely to be 10% less well off for the rest of their lives with more poverty to come depending of what inflation is for the rest of their lives.

A slight exaggeration as while their fixed annuities are worth 10% less, their State Pensions are linked to inflation. So they are worse off by 10% times whatever percentage of their total income is the level annuity.

The more well off someone is, the less likely they are to buy an annuity, so it would be an unusual for someone's level annuity to dwarf their State Pension(s).

And RPI linked annuities can be 50% less than level annuities in the first year.

The rapid rise now of inflation is going to reap dividends for those who opted for this type of annuity in the past. Annuities are a form of insurance. 

Depends how long ago and where inflation goes in the future.

An overall positive return is better than a negative one. The longer term impact of compounding is rarely considered. When it's a choice of jam today or jam tomorrow. 

LHW99

And another advantage of an annuity when you get towards 75+  is that when the marbles start to rattle, the cheque will still come in.

OldScientist

To add to some excellent responses above (and my apologies for a long post), perhaps an example approach to evaluating the effectiveness (or otherwise) of an annuity purchase might help you decide (you’ll need to put your own figures in). Assume a single 67 year old, full state pension (9.6k), £360k portfolio, essential expenditure £12k, discretionary expenditure £9k (overall expenditure of £21k supporting a ‘moderate lifestyle, see https://www.retirementlivingstandards.org.uk).

Assuming 30 year lifespan (i.e. to 97, roughly 10% chance of exceeding this) and a 50% stocks and 50% bonds portfolio, then (according to https://www.2020financial.co.uk/pension-drawdown-calculator/) a UK-based portfolio would have a maximum withdrawal rate with no historic failures (i.e. SAFEMAX) of 2.95% (to the nearest, unfeasibly accurate, 0.05%). Assuming international diversification would give an additional 30 basis points to the SAFEMAX and fees (say 0.35%) would reduce it by 15 basis points, then a reasonable estimate of the historical SAFEMAX might be 3.1%.

So, portfolio income would be 360*0.031=£11.2k for an overall expenditure of 9.6+11.2=£20.8k (near enough to £21k then).

According to https://www.hl.co.uk/retirement/annuities/best-buy-rates, a single life annuity with RPI protection would currently give an income of 2.9% of premium at 65 and 3.75% at 70. Assuming a roughly linear interpolation between the ages of 65 and 70, then at 67, the annuity would provide an income of 3.2% (rounded down to nearest 0.1%) of premium.

A sensible strategy might be to cover the essential expenditure requirement (i.e. £12k) with guaranteed income, i.e. 12-9.6=£2.4k, leaving the portfolio to cover discretionary expenditure and legacy requirements. To purchase £2.4k of income with an RPI annuity would require a premium of £75k. Given that annuities consist largely of bonds (and other similar instruments), then one approach would be to purchase the annuity using the bond portion of the portfolio. This would then leave the portfolio with £180k stocks, and £105k of bonds. This means that the portfolio is now roughly 63% stocks and 37% bonds which means that the SAFEMAX then rises to 3.05% for a UK portfolio (again round to nearest 0.05%) and to approximately 3.2% allowing for international diversification and fees.

Overall, after the annuity purchase, the income would be derived as follows

Pension £9.6k

Annuity £2.4k

Portfolio £8.8k (to give the same income of £20.8k as above, which is a withdrawal rate of approximately 3.1% of the remaining portfolio).

Pros:

- With the annuity, portfolio would have survived an additional 3 years (i.e. until 100) before a historical failure occurred (whereas, with no annuity the portfolio only survived until 97, i.e. no additional time beyond the planned 30 years).

- If future stock market returns are lower than historically (and, consequently, the UK SAFEMAX is also lower), then with the annuity purchase essential income is covered even in the event of premature portfolio exhaustion.

- With essential income covered, a variable withdrawal method (e.g. VPW, seehttps://www.bogleheads.org/wiki/Variable_percentage_withdrawal) could be used instead of the inflation-adjusted withdrawals approach which will ensure that the portfolio survives and, in good market conditions, allow more discretionary spending (but with potentially lower instantaneous income in poor markets).

Cons:

- In this example, about 20% of the portfolio has been spent on the annuity, which means that any legacy will then be reduced by approximately 20% (approximately, because if death occurs during the 5 year guarantee period, then £2.4k*N, where N is the number of years remaining before the guarantee expires, will be paid to the nominated beneficiary and the additional portfolio survivability resulting from the annuity purchase means that a small additional amount of legacy would also be available from that source).

At current annuity with RPI prices it appears that the financial breakeven point for purchase (for a single person) lies somewhere between the ages of 65 and 70. For example, following the above process for a person aged 55 (left as an exercise for the reader) shows that historically the portfolio was a clear winner (even though the portfolio then has to last about 40 years), while for ages 70 and above, the annuity would be an even better choice than at 67.

I’ve deliberately chosen a simple example – the calculation is more complicated for a couple (and the financial breakeven age will be higher once a 100% survivor benefit is added, although the portfolio will also have to last about 3 years longer with a couple than for a single person). Inclusion of taxes (which I have ignored) will also add to the complexity.

Albermarle

Although the SWR seems a bit low for a 65 year old ( noting of course that SWR is only a theory anyway ) , it is expected that annuity rates will increase/are increasing . In which case your well worked example still is valid even if you bump up the SWR a bit .

Secret2ndAccount

OldScientist, very interesting analysis, and a good idea. A couple of thoughts:
1. Reduced inheritance. You could perhaps equate the two pathways more completely by factoring in the cost of a decreasing series of life insurance policies, purchased out of the annuity income. This could then get the heirs back to the same position as before the annuity purchase. Difficult to get life insurance for a 70 yr old I guess.
2. Holding on to your pot increases flexibility. My friend wanted to downsize and move closer to her daughter. By using her pot as a bridging loan, she was able to move immediately, rather than wait for her house to sell. Effectively she received a rate of return of 5% on the pot - the cost of the loan (which she wouldn't have been able to get) for the time until the house sold.
Also, if you find that your days are numbered, you can choose to burn down your pot - ticking items off the bucket list, or paying for 24 hr care while you spend your last days comfortably in your own home. Can't do that with an annuity. Hard to assign a numerical value to that, or conversely to the guaranteed safety of annuity vs managing your own money with failing faculties. At some point it becomes a personal choice.

Pensions_matter_2

Thats a good analysis and these are important points Oldscientist and Secred2ndAccount. Keeping options open, so there is flexibility to adapt at you age and your requirements change, is worth keeping in mind if its affordable.

OldScientist

Albermarle said:

Although the SWR seems a bit low for a 65 year old ( noting of course that SWR is only a theory anyway ) , it is expected that annuity rates will increase/are increasing . In which case your well worked example still is valid even if you bump up the SWR a bit .

Agreed, effectively varying the SWR will change the age where buying an annuity might make financial sense (increasing SWR will raise the age and vice versa)

The only paper to deal with the difference on SWR between holding domestic stocks and bonds and a global portfolio (as far as I know - if anyone has another link particularly for the UK, that'd be nice) is by Pfau and can be found at https://www.advisorperspectives.com/articles/2014/03/04/does-international-diversification-improve-safe-withdrawal-rates

According to the results presented by Pfau, for the UK, holding a portfolio of domestic 50% stocks and 50% bonds, the SAFEMAX is 3.05% (no fees), while for global 50% stocks and 50% bonds held in the UK the SAFEMAX is 3.26%.

In other words, the calculation of SAFEMAX at 2020financial for the UK (2.95%) is probably close enough (that calculator uses a different returns and inflation dataset to those used by Pfau) and my addition of 30 basis points for international diversification possibly slightly generous. As for the effect of fees, Kitces (https://www.kitces.com/blog/the-impact-of-investment-costs-on-safe-withdrawal-rates/) calculated that a 1% fee would lead to a reduction in SWR~0.4% (for US portfolios - I've done similar calculations for the UK and it is not too different), so dropping the SWR by 0.15% for a fee of 0.35% (platform+fund) is probably about right.

OldScientist

Secret2ndAccount said:

OldScientist, very interesting analysis, and a good idea. A couple of thoughts:
1. Reduced inheritance. You could perhaps equate the two pathways more completely by factoring in the cost of a decreasing series of life insurance policies, purchased out of the annuity income. This could then get the heirs back to the same position as before the annuity purchase. Difficult to get life insurance for a 70 yr old I guess.
2. Holding on to your pot increases flexibility. My friend wanted to downsize and move closer to her daughter. By using her pot as a bridging loan, she was able to move immediately, rather than wait for her house to sell. Effectively she received a rate of return of 5% on the pot - the cost of the loan (which she wouldn't have been able to get) for the time until the house sold.
Also, if you find that your days are numbered, you can choose to burn down your pot - ticking items off the bucket list, or paying for 24 hr care while you spend your last days comfortably in your own home. Can't do that with an annuity. Hard to assign a numerical value to that, or conversely to the guaranteed safety of annuity vs managing your own money with failing faculties. At some point it becomes a personal choice.

Life Insurance is a good idea (I'm using a similar approach to plug a potential gap in my OH's income if I die prior to their state pension age) - currently our income is almost entirely drawn from my DB pension which will halve in that case. I suspect you are right that insurance may not be easy to obtain at 70 or, more likely, very expensive.

I guess the other point in terms of inheritance - the inflation-adjusted approach leaves a huge range of potential pot sizes at all ages depending on market conditions, i.e. luck (e.g. after 30 years, anything between close to 0 and, in real terms, 10 times the original pot), so to some extent a 20% loss of legacy value (as in the example) is rather lost in the noise.

I'd completely agree with your final point - the financial calculations and numbers are one thing, but the intangibles (and you've mentioned some important ones) means personal choice is what it comes down to.