When it comes to retirement options it’s fair to say annuities have received a bad press over the years. They are usually portrayed as extremely poor value in comparison to approved retirement funds (ARFs), with scant attention paid to their advantages. But with interest rates on the rise and global economic volatility increasing, maybe it’s time for a reassessment.
It may be difficult to fathom now, but it’s not so long ago that annuities were the only game in town for defined contribution scheme members and personal pension plan holders. Until 1999, when the then finance minister Charlie McCreevy introduced ARFs, the only flexibility open to those people was how much they wanted to draw down in their lump sum – the remainder had to be invested in an annuity.
That wasn’t always a terrible restriction, however. Back in the good old bad old days, annuity rates were very attractive, or appeared so at least. In the late 1980s and early 1990s rates of around 10 per cent were available. That meant a person with a €500,000 pension pot to invest would get a €50,000 annual pension guaranteed for life.
Hands would be bitten off for a similar deal today.
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Like all these things, however, this must be placed in the context of the time. Interest rates were sky high – in double digits for long periods − and inflation was even higher at times. That meant the real value of your retirement income was going to diminish quite significantly over time.
The other thing that has changed is life expectancy. It must be remembered that an annuity is an insurance contract that converts your pension fund into a guaranteed income for the rest of your life. How long you are likely to live, therefore, has a profound influence on the income you’re going to be offered.
Back in 1990, the life expectancy for the average Irish person – if such a being exists – was 74.8 years. In other words, someone retiring at 65 could expect to be receiving a pension for 10 years.
Life expectancy today, on the other hand, is 82.9 years, meaning that the same individual can expect their pension to be paid for almost 18 years. That’s a very big difference.
With interest rates plunging in the late 1990s and early 2000s and again in the post-crash period, annuity rates fell to around 3 per cent in the worst cases. Instead of €50,000 a year, our individual with a €500,000 pension pot could expect €15,000. Not very attractive at all.
Further compounding the loss of appeal is the fact that annuities die with you. Payments from a standard annuity cease upon death, with any residual amount reverting to the insurance company. If you die within a few years of retiring, you’re on the wrong side of the deal. Of course, if you beat the actuaries and live on into your 90s, you’re on a winner.
Things aren’t so extreme today, and rates of 6 per cent and above are available in the market. That leaves the €500,000 pension pot holder with a choice of a guaranteed €30,000 pension for life or taking their chances with an ARF which is a personal investment account offering tax-free growth but subject to normal market rises and falls.
Munro O’Dwyer, who leads PwC Ireland’s retirement and pensions consulting business, agrees that annuities appeared to offer “really poor value” at one stage. That is no longer the case, however.
“Today, with higher interest rates, they are much more plausible,” he says. “Annuities can be thought of as almost like a bond. It was rational when bond yields were really low that you mightn’t invest in an annuity, but that factor has been removed. So, they need to be relooked at. That’s probably the best way to think about it.”
The fact that the annuity dies when you do is a “brilliant property”, he believes. “You can consider that a positive or a negative. But to my mind, if your objective is to spend all of your money, it’s a positive. We can catastrophise and say, what if I get run under a bus? And that can happen. But it’s far more likely you’ll be alive at 100. And the annuity carries on as long as you do. You can spend what you get every week because you know it’s coming the next week if you’re alive. With other products, you can never spend it all. People don’t always think about this that carefully.”
It’s very hard to spend all the money with an ARF. In fact, the great majority of people work very hard at avoiding that eventuality – known as the “bomb out” scenario in the industry – because if it does happen, there will be no pension payments after that.
O’Dwyer says people need to understand the fundamental difference between the two products and contends that people will get lower income from an approved retirement fund. “I know people won’t agree with me, and I know people in the advice community won’t agree with me, because what they’ll say is you can invest and get higher returns and get a higher income from an approved retirement fund. But what they have done is introduce risk into the system without properly explaining it. It does not make sense that you can have an approved retirement fund and a higher income and not have introduced risk into the system.”
In other words, if you take the risk out of the ARF and invest accordingly, you’re going to get a lower income than you would with an annuity. And while you’re paying for the certainty of an annuity through perceived lower returns, you also pay for the potential of higher returns from an ARF through higher risk.
“You can take more risk, but your adviser should be very clear with you that that is what you’re doing,” O’Dwyer points out. “And risk works in two directions. It can bring more income, but it can bring less income and there’s no guarantee of greater income. You’re giving up guarantees and you’re taking on risk.”
Bernard Walsh, head of investments and pensions at Fairstone Ireland, believes annuities still have a role to play. “They hark back to the days of defined benefit pensions when people had a sense that someone was looking after them. They like the feeling of their salary, or part of it, continuing. You can pick the payment date, and many people select the same date as their salary used to be paid.”
Along with that sense of comfort, higher bond yields are making them a bit more attractive, he adds. “Also, you need to look at the totality of pensions. If two people in a relationship are retiring, one can choose an ARF and the other can choose an annuity. That gives them a mix of growth potential and certainty. Also, if someone retires with a number of pension pots from different employments, they can put one of them into an annuity and the others into an ARF.”
Flexibility is an important consideration, he adds. “One of things a lot of people don’t necessarily realise is that they can decide to buy an annuity later with some or all of the money they have in their ARF. However, if you buy an annuity at retirement, it’s game over. The decision is made for all time.”
And when it comes to purchasing an annuity, shopping around is very important. “Most pension schemes will allow you to choose from the open market,” says Walsh. “You can purchase an annuity from a range of providers.”
He notes that on one day in September, one insurer was offering a rate of 6.2 per cent. “That would give someone with a €500,000 pension pot an income of €31,000 per annum for life. Another insurer was offering 5.71 per cent, which would translate into €28,475 per annum.” Over 20 years that’s a difference of €50,500.
O’Dwyer concludes by advising people to think ahead to the longer term when making their decision. “Don’t just think about the 60-year-old you, because you’re not buying these products for the 60-year-old you. You’re buying it for the 70, the 80, the 85-year-old you. With an annuity, there’s no management to it. The big attraction of an annuity is you don’t have to deal with financial advisers any more. It just works and you don’t have to deal with people like me.”
