The announcement of “pension freedoms” in the 2014 UK Budget received a rapturous response. No longer would people be forced at retirement to convert their pension pot into an income for life. Instead, they would be free to move it into a flexible drawdown arrangement, tapping into their retirement pot whenever they wished, or even to cash it out in full.
Following the announcement, annuity sales plummeted and the Financial Conduct Authority (FCA) estimates that over £45bn has been “flexibly” withdrawn from pensions since implementation in 2015.
Yet annuities were never an inherently bad product. Although falling interest rates and rising life expectancy had sharply increased the cost of buying an annuity, having a guaranteed income for life is hardly a bad outcome for a lifetime of pension saving.
The big problem was the all-or-nothing nature of the deal. For someone who wanted to make their money work harder and enjoy some flexibility, locking into an annuity at retirement made little sense.
But the unanswered question around pension freedoms is “what happens next?” While drawdown may look right at the point of retirement, does that choice still look right years later? If not, how should savers be nudged towards reviewing that choice?
A new research paper I have written jointly with Philip Boyle, which is published today by LCP, offers some answers.
The paper takes as a baseline someone aged 60 who retires and converts their accumulated pension pot into a standard level annuity, paying an annual income of just under 4 per cent of the value of their pot.
It then assesses if the same individual is better or worse off if they opt instead for a drawdown account where the pot is invested for growth. It is assumed that they sustain a regular income of 130 per cent of the amount which would have been generated by an annuity. But because the funds generally involve significant exposure to equities, they also run the downside risk of seeing their portfolio fall and even of running out of money.
LCP’s analysis then examines 2,000 different simulations covering a range of potential future scenarios covering different patterns and levels of investment return and also different lengths of life.
The model gives an average score to the individual from each of the two strategies — drawdowns and annuities: it takes account of the satisfaction obtained when investments perform well, the considerable dissatisfaction if you run out of money, and the modest satisfaction of having money left to pass on to others as an inheritance.
This process is repeated for the individual at age 61, age 62 and so forth through their retirement. The results are shown in the chart.
The analysis confirms that at age 60 the optimal strategy for the individual is likely to be to enter drawdown. This would generate a 10 per cent higher satisfaction score than an annuity, chiefly because the individual stays invested for longer.
But, crucially, there is a crossover point at which an annuity becomes more attractive. Based on the assumptions we have made about this individual’s attitudes and goals, the crossover point is around age 67. Beyond this age, an annuity becomes progressively more attractive. mainly because the removal of longevity risk becomes increasingly more appealing.
Naturally, the relative attractiveness of drawdown and annuity will vary from individual to individual. So we also test how our results are affected by different assumptions about the investment mix of the drawdown product, about the attitude to risk (and loss) of the saver and so forth. What is striking in our analysis is that there is always an age where buying an annuity becomes the best option — though the crossover point varies considerably depending on the assumptions.
Suggesting that an annuity could be attractive may seem surprising at a time when inflation is on the increase. But while higher inflation could erode the real value of a level annuity and could delay the optimal age for switching, there is still a point later in retirement where the switch makes sense.
One crucial driver of our results is the fact that life expectancy becomes proportionately more uncertain as you get older, and hence the certainty of an annuity becomes more valuable with age.
To illustrate this point, consider a man aged 60. His life expectancy is around 26 years, so on average he should live to 86. When managing his retirement pot in drawdown what matters is not just spreading that pot over 26 years but also planning for what happens if he lives much longer. However, at 60 he can essentially forget about the “risk” of living double the average lifespan, as this would mean living to the age of 112.
Now consider a man aged 80. His average life expectancy is just over eight years, so he might plan to make his money last to age 88. But in this case it is not inconceivable that he could live twice as long as expected — to age 96. Indeed, the Office for National Statistics suggests that around one in nine men aged 80 will live to 96, so this is a risk he cannot ignore.
As this example illustrates, the proportionate uncertainty of life expectancy rises as you get older, which makes annuities look a much better deal as you progress through retirement.
Our findings have big implications. Individuals need to consider whether switching some or all of their funds into an annuity later in retirement should be part of their strategy. Pension providers need to look at whether drawdown products need to be designed with later life switching in mind. And policymakers need to consider whether the approach of nudges and defaults, which has worked well in the accumulation phase, now needs to be applied as people manage their money through retirement. Without this, pension freedoms will remain unfinished business.
“Is there a right time to buy an annuity” by Philip Boyle and Sir Steve Webb, a former pensions minister, is available at lcp.uk.com
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