Why buy annuity

MarkCarnage

Insurers use IL gilts to hedge inflation for IL annuities.

In practice, they use the derivatives (swaps mainly) in combination with the actual asset (proportion varies according to relative value) and most of their book is in investment grade corporate credit plus some other low risk assets which give cashflows matching their liability book. 
They also lay off some of the risk to reinsurers but that's another story....

zagfles

Cobbler_tone said:

In real terms how much does inflation matter to a large percentage of the older generation?

In many instances....no mortgage, no car, no fancy holidays. 
The cost of heating their home and cost of smoked salmon in M&S is probably the key driver for many.
Not forgetting that if inflation is high, so are saving rates. My parents and partners parents are both working class retirees with more money than they have ever had.

Recognising of course that for those renting and potentially living on the limit that it really matters.
If you are going to invest in high risk stuff, then you are always more likely to come a cropper. Hence why the older folk often stick to a good old bank account and cash in envelopes! I know my dad still draws £250 cash (state pension) every Monday and hands my mum 'housekeeping' and stuffs the rest in a bill envelope!  It works for them.

It matters far more to them than most. If you don't have "fancy holidays" etc then you'll have less to cut back on. If you have a job you'll likely get payrises in line with inflation. If your income is fixed or inflation increases are capped like a lot of DB pensions then you're the worst affected, if inflation becomes a big issue. Which obviously it might not. 

zagfles

MK62 said:

zagfles said:

MK62 said:

zagfles said:

OldScientist said:

arthur_fowler said:

zagfles said:

arthur_fowler said:

zagfles said:

I can't see the point of flat annuities. You just replace investment risk with inflation risk. Even IFAs don't seem to understand this when they waffle on about breakeven points based on guesses about inflation. The point of an annuity isn't to do what maximises lifetime income. Use drawdown for that. The point is to provide a guaranteed income for the rest of your life to pay bills, shopping etc, which will likely increase with inflation, which is unknown just like stockmarket returns. 

Again, it depends......

For us a flat annuity I believe was the correct route to take. Rationale is:
1) We have various DB pensions plus full SPx2 that will kick in over the next 7 years (retiring at 60). These will mitigate (but not remove) inflation risk
2) We want a (relatively) higher income in the next ten years while we are hopefully fit and well enough to travel a lot (which is what we like to do).

1) If private sector DB pensions which usually have caps on inflation increases, that's even more reason to mitigate with something fully inflation protected. A decade like the 1970's would about halve the DB pension value if inflation increases are capped at 5%. Even one off high inflation will permanently dent a DB pension in payment, a single year of 10% as we've seen recently would chop about 5% real value off a DB pension if capped at 5% inflation increase, or 7% if capped at 3%, every year into the future, even if inflation returns to 2% or so.
(It's not so bad in deferment as the cap applies across the entire period of deferment, but once in payment lumpy inflation can serious dent DB pensions)

2) Front loading retirement spend may be sensible but a flat annuity fronts loads by an unknown amount. You can easily front load retirement income to get predictable real income for instance using an IL gilts ladder, or a short term annuity, in addition to a lifetime IL annuity. 

Yes, of course mitigating inflation risk entirely is possible but it is very expensive

While I agree that front loading using a level annuity is a reasonable case (IMO, probably the only reasonable one) but the outcome depends on sequence of inflation. A run of nasty years (annual inflation of 20% plus occurred several times in the UK in the 20th century) very early on after purchase will destroy the purchasing power of a level annuity in both the short, and particularly, the long term. How expensive IL protection turns out to be can only be determined in retrospect (if inflation is low, then very expensive, if inflation is high, very cheap!).

Yes sequence of inflation is very important, just as important as sequence of returns when talking about drawdown. But I suspect most people, maybe even advisors, who model flat vs RPI annuities just assume constant inflation. 

I've modelled retirement at 65 assuming that the uplift for a flat annuity is 56% (as per Annuity Rates: View Best Annuity Rates from the UK Market) 

At 3% inflation, the flat annuity pays more until age 80 and the cumulative (real term) total income is higher for flat until 98. Looks like a no-brainer, right? 

Even at 5% inflation, the flat annuity pays more till 74 and the cumulative is more till 85. 

But put in some real sequences. 

1970: the flat pays more for just 4 years, till 69, and the cumulative total is more till just 73. At 74 you're now down overall and living on an income a third of the initial real value and half what you'd have had with an index linked annuity.  By age 80 your income is less than 20% of its initial value and 30% of the index linked annuity. 

1980: the flat pays more till age 72 and the cumulative cut over is age 80, when you're now on 70% of what the IL would have paid and reducing in your 80's down to 55%

1990: A lot better for flat, pays more till age 80 and the cumulative cut over would have been last year, age 98. 

2000: Flat pays more till 81, cumulative cut over not happened yet (now aged 89), current income just under half initial and 76% of what an IL would have been. 

So a flat annuity would have been a disaster in 1970, it would have been bad in 1980 assuming average life expectancy, and it would have likely been better in 1990 and 2000. But the downside of a 1970's like start is far worse than the upside of later years. 

All true, but it rather assumes your whole retirement income comes from said annuity alone........if you split your pot so that your income is part annuity/part drawdown, then you should also model what happened to the drawdown part of the pot during the same periods......

Indeed - that would be an interesting model. But the problem is drawdown seems to be analysed to death using historical sequences going back 100 or even 200 years, but the same isn't done for flat annuities. Inflation risk isn't analysed in the same way as stockmarket risk. It should be. It's as if people assume inflation risk is a thing of the past. I'll give it a go...

In 1970 the basic state pension was £260 a year. Not really enough to live on, but plenty of people did. Someone then who was retiring and had built up a massive pension pot of £10k would have done very well. £10k was a massive amount of money then, enough to buy a 4 bed detached house in a decent area of London. 

What are they going to do with that £10k? (assuming today's pension freedoms/option)

1) Buy a flat annuity at say £750 a year. That plus the state pension of £260 would be a 4 figure income, a target in those days, around the average wage and a luxury retirement then. Maybe they'd be worried about inflation. Buy why? Inflation had averaged 3.5% over the previous 10 years, and under 4% over the previous 20. Inflation wouldn't have looked any more of an issue then than now. 

2) An index linked annuity at £480 a year. Total of £740 a year. Still a good retirement income, but below average wage. 

3) Go into drawdown, say drawing 4.5% increasing with inflation. Even less income. But hindsight says that would be worked according to https://forums.moneysavingexpert.com/discussion/comment/80495432#Comment_80495432

4) Or a mix, say a flat annuity with 2/3rds of the pot and drawdown with a third. We can draw more because we have the "security" of the flat annuity, haven't we? So £500 annuity and 7.5% drawdown on £3333 giving £250. Got our 4 figure income with the state pension. 

By 1980 (age 75):

1) would be living on an income of £2162 (£750 annuity plus £1412 state pension). Average wage then was £6000. They'd have gone from living on an average wage to living on just over a third of the average wage. 

2) would be living on £2972 (£1560 annuity plus £1412 state pension), about half the average wage. 

3) would be about £2850, slightly lower than 2)

4) would be £2712 even if the 7.5% drawdown increased with inflation. However the pot would be running dangerously low if they'd done that.

By 1990 (age 85): 

1) would be living on an income of £3189 (£750 annuity plus £2439 state pension). Average wage was £15k. 

2) would be living on an income of £5615 (£2439 state pension plus £3176 annuity)

3) would be be living on £5417

4) would be living on £2939 as the drawdown pot would have probably run out. Either than or they'd have had to reduce the DD and cut their spending to the bone. Utter disaster. 

So it seems mixing a flat annuity with drawdown proves even worse than using the whole lot for a flat annuity in the worst case scenario (ie 1970). Pure drawdown gives a much better result, but not as good as an IL annuity. 

Run a simulation from 2000 and the reverse is true.......the IL annuity would have proved costly if used alongside drawdown.
In the end though, there is no way way to know which will prove the better option........annuity providers price them so that, on average there will be no difference......half the time an IL annuity will be the better option and half the time a flat annuity will be.

A far better mix would likely be an index linked annuity with drawdown. You can use the IL annuity to secure a guaranteed real terms income you're happy with, and then it doesn't really matter what happens to the drawdown, you can spend it all in the early years on luxury holidays etc and if it does well that could last for 20 years, if it does badly maybe 10 years, but you know you'll be OK when it runs out. You don't know that with a flat annuity.

Again true, but then it's also true that securing an income you are happy with will cost a lot more if you use an IL annuity.......and will leave you with a smaller drawdown pot which will likely run out sooner......you can't have it both ways. 

If you want £10k as a base income from an annuity, then for a 60yo that will cost £148k for a flat annuity and £232k for an index linked version. So, taken to the nth, in effect it becomes a £10k index linked annuity versus a £10k flat annuity coupled with withdrawals from an £84k drawdown pot.......there is no way to know today which option will turn out to have been the better choice. 

Well obviously but you seem to have missed the point. It's not about what's most likely to get you the best result. It's about what is "safe". In the same way as the SWR. The SWR is based on worst case scenarios for drawdown, I was doing the same with inflation for flat annuities. 

zagfles

OldScientist said:

Finally, since I said I'd include another couple of historical cases, here are 1910 (fairly bad for stock/bond portfolio) and 1970 (actually OK for stock/bond portfolio - note the target WR of 5% instead of 3.5% - but horrible inflation). In each case, the highest annuity payout rate is for a single life level annuity aged 67 based on historic yields and modern mortality rates.





For the 1910 case there was deflation during the 1920s (that's why the income from the annuity goes back up - IIRC, the last occasion when we had some deflation in RPI was 2008). The large effect of inflation on the annuity income during the 1970s can also be seen and the annuity only marginally improves things even at the highest payout rate. However, in each of the example cases, provided the payout rate was high enough, the level annuity improved the outcome compared to just running drawdown. In some respects, this should not be too surprising since the retiree is swapping bonds held in their portfolio for a collapsing bond ladder held by the insurance company (with a small boost due to mortality rates).

I've looked at this in a more systematic way and found that provided the payout rate for a level annuity exceeded a threshold of somewhere between 5.5 and 6.0% it would have improved the outcomes for the worst historical cases in the UK.

I might have missed something but the 1970 graphs seem to show income plummetting in about 1992/3 with the pure drawdown but 1987 with the DD/8.5% annuity. Or are you adding a couple of decades of the continuing 0.5% or so annuity income? 

zagfles

MarkCarnage said:

Insurers use IL gilts to hedge inflation for IL annuities.

In practice, they use the derivatives (swaps mainly) in combination with the actual asset (proportion varies according to relative value) and most of their book is in investment grade corporate credit plus some other low risk assets which give cashflows matching their liability book. 
They also lay off some of the risk to reinsurers but that's another story....

I presume that the the underlying assets are generally IL gilts for IL annuities, or are there other assets which can liability match IL annuities? They all seem to use RPI as the inflation measure, same as IL gilts. 

Cobbler_tone

zagfles said:

Cobbler_tone said:

In real terms how much does inflation matter to a large percentage of the older generation?

In many instances....no mortgage, no car, no fancy holidays. 
The cost of heating their home and cost of smoked salmon in M&S is probably the key driver for many.
Not forgetting that if inflation is high, so are saving rates. My parents and partners parents are both working class retirees with more money than they have ever had.

Recognising of course that for those renting and potentially living on the limit that it really matters.
If you are going to invest in high risk stuff, then you are always more likely to come a cropper. Hence why the older folk often stick to a good old bank account and cash in envelopes! I know my dad still draws £250 cash (state pension) every Monday and hands my mum 'housekeeping' and stuffs the rest in a bill envelope!  It works for them.

It matters far more to them than most. If you don't have "fancy holidays" etc then you'll have less to cut back on. If you have a job you'll likely get payrises in line with inflation. If your income is fixed or inflation increases are capped like a lot of DB pensions then you're the worst affected, if inflation becomes a big issue. Which obviously it might not. 

With respect, my point was regarding the older generation I know, whom I'd imagine are not unique at all. Well I know they are not as they are five couples I know who are totally unrelated, one of which are my parents.
There will be a lot of people who bring in £25-40k a year into old age with very minimal outgoings, £15k max. I wasn't alluding to those who can't afford to go on the fancy holidays, maybe those who choose not to or are not physically able to. With the triple lock, I am very confident that my folks don't outspend what they receive in state pension, so my dad's work pension will be 'free' money.

My parents had 3 kids and a very basic lifestyle, totally their choice but similar to many of their peers and typical of that generation. My dad was a lorry driver for 40 years and my mum a home help, so hardly top earners. I know for a fact that my mum has never had to spend a penny of her state pension and she has been receiving it for 22 years. She also didn't spend any of her wages for the last 5 years of working. Exactly the type of couple who won't miss the winter fuel allowance. I do pull her leg and question what she is saving for.

Totally recognise that everyone's situation and story is different. Living on a state pension alone in London or further south can't be much fun and high inflation will clearly impact on people that are already scraping by.

If we are talking about a DB pension not being inflation proof, then whoever has one already has a decent head start! 

zagfles

Cobbler_tone said:

zagfles said:

Cobbler_tone said:

In real terms how much does inflation matter to a large percentage of the older generation?

In many instances....no mortgage, no car, no fancy holidays. 
The cost of heating their home and cost of smoked salmon in M&S is probably the key driver for many.
Not forgetting that if inflation is high, so are saving rates. My parents and partners parents are both working class retirees with more money than they have ever had.

Recognising of course that for those renting and potentially living on the limit that it really matters.
If you are going to invest in high risk stuff, then you are always more likely to come a cropper. Hence why the older folk often stick to a good old bank account and cash in envelopes! I know my dad still draws £250 cash (state pension) every Monday and hands my mum 'housekeeping' and stuffs the rest in a bill envelope!  It works for them.

It matters far more to them than most. If you don't have "fancy holidays" etc then you'll have less to cut back on. If you have a job you'll likely get payrises in line with inflation. If your income is fixed or inflation increases are capped like a lot of DB pensions then you're the worst affected, if inflation becomes a big issue. Which obviously it might not. 

With respect, my point was regarding the older generation I know, whom I'd imagine are not unique at all. Well I know they are not as they are five couples I know who are totally unrelated, one of which are my parents.
There will be a lot of people who bring in £25-40k a year into old age with very minimal outgoings, £15k max. I wasn't alluding to those who can't afford to go on the fancy holidays, maybe those who choose not to or are not physically able to. With the triple lock, I am very confident that my folks don't outspend what they receive in state pension, so my dad's work pension will be 'free' money.

My parents had 3 kids and a very basic lifestyle, totally their choice but similar to many of their peers and typical of that generation. My dad was a lorry driver for 40 years and my mum a home help, so hardly top earners. I know for a fact that my mum has never had to spend a penny of her state pension and she has been receiving it for 22 years. She also didn't spend any of her wages for the last 5 years of working. Exactly the type of couple who won't miss the winter fuel allowance. I do pull her leg and question what she is saving for.

Totally recognise that everyone's situation and story is different. Living on a state pension alone in London or further south can't be much fun and high inflation will clearly impact on people that are already scraping by.

If we are talking about a DB pension not being inflation proof, then whoever has one already has a decent head start! 

With respect, you seem to have missed the point. It was about how inflation matters to people. That was, after all, what you asked. Not whether people are affected now, in what has been a relatively low inflation period apart from the short spike a couple of years ago. 

If inflation were to be high and sustained, it will likely matter more to those who have incomes which don't keep up with inflation. More likely - pensioners. Some will have the capacity to absorb it. Other won't. 

Bringing in £25-40k, about the average wage, would be the same as the 1970 example I gave earlier. If their income wasn't inflation linked (apart from the state pension) then in that scenario they'd be living on about a third of the average wage 10 years later. 

Cobbler_tone

But £25k (for a couple) are protected from inflation to a certain extent, unless you mean if the state pension is frozen, which is a different conversation. Hence why those in later life are normally more concerned about savings rates as opposed to mortgage rates and inflation.

I’d say the families pulling in £40k a year, with a hefty mortgage and 3 kids, running a car etc are more vulnerable to large spikes in inflation. People in that category must be really feeling the pinch.

zagfles

Cobbler_tone said:

But £25k (for a couple) are protected from inflation to a certain extent, unless you mean if the state pension is frozen, which is a different conversation. Hence why those in later life are normally more concerned about savings rates as opposed to mortgage rates and inflation.

I’d say the families pulling in £40k a year, with a hefty mortgage and 3 kids, running a car etc are more vulnerable to large spikes in inflation. People in that category must be really feeling the pinch.

Yeah if they're happy to live on the state pension they'll likely be fine. If they have fixed/capped income over it, that's going to be affected by high inflation (eg a flat annuity or a capped DB pension). 

The family on £40k would likely get pay increases in line with inflation, plus inflation is generally good for people with debt (such as mortgages) as the real value of the debt reduces faster. My parents had an £8k mortgage in the early 1970s which was massive then, by the late 70s/early 80s their repayments were trivial. 

Most of us here were probably kids in the high inflation period of the 70s. What do you remember? I remember us being fine, our parents being fine and not struggling for money, but grandparents (ie the pensioners of the time) generally being poor.

Hoenir

zagfles said:

Most of us here were probably kids in the high inflation period of the 70s. What do you remember? I remember us being fine, our parents being fine and not struggling for money, but grandparents (ie the pensioners of the time) generally being poor.

The world changed in the early 70's when banks were set free. Able to leverage their balance sheets and use fractional reserve banking to their benefit. There's a great easy to comprehend book called 

How an Economy Grows and Why It Crashes

Who knows perhaps another economic era is drawing gradually to a close.