Buttonwood
Freedom or licence?
Annuities are not as bad as they are sometimes painted
Mar 29th 2014
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LET the pensioners free. That was the rallying cry of the recent British budget, which decreed that those who accumulate a pension pot no longer must use the proceeds to buy an annuity on retiring.
The change will bring Britain into line with America and Australia, where those retiring have immediate access to their pension pots. But Canada, Singapore and Sweden still impose fairly tight restrictions on what they can do with their money, as do Denmark and the Netherlands, two countries with widely-admired pension schemes.
Many people believe annuities, which transform a pot of cash into regular payments until the beneficiary dies, are a bad deal. Certainly, the failure of Britons to shop around for the best rate when they retire (the so-called open-market option) means that some lose out. But the two main reasons why annuity rates have fallen are fundamental; first, people are living longer and second, the general level of interest rates has fallen.
Pensioners exercising their new-found freedom need to take account of both factors. In 1960 British males who reached the retirement age of 65 could expect to live a further 12 years; now it is almost 19 (and 21 years for females). The income from any given pot has to be lower because it needs to last longer.
Meanwhile, interest rates are low because central banks are worried about the health of the Western economies; thanks to deteriorating demography, we may have moved to a slow-growth, low-rate world.
Think of an annuity as paying the equivalent of the market’s risk-free rate. It is possible to earn a higher return than the risk-free rate but only by taking a risk; and people may underestimate the dangers. Suppose investors decided to put their entire pension pot into equities and to take an income of 5% a year; if the stockmarket fell by 40%, as it did in 2008-09, then half the pension pot would be gone within two years. Nor do equity markets necessarily rebound; the Tokyo stockmarket is still only a third of the peak reached in 1989.
Investors may also underestimate the costs of riskier investing. Annuity rates are net of fees but those who invest in a mutual fund may be subject to expenses and fees of 2% a year. Many people may prefer to invest their nest-egg in a buy-to-let property. But what if they pick a house on a flood plain, or a property where recalcitrant tenants cause substantial damage or refuse to pay rent for a while? Pensioners may then be stuck with an illiquid asset, with high repair bills and uncertain income.
The chart shows how many years a pension pot will last (on plausible rates of return), for various levels of income. Beating annuity rates (currently 6% for a 65-year-old male, or 4% with inflation-linking) is not automatic.
Of course, buying an annuity involves risk as well. The annuity purchase might occur at an unusually unfavourable moment. There is the risk, if the buyer opts for a fixed-rate annuity, that the income might be eroded by rapid inflation. Conversely, if the buyer opts for an inflation-linked annuity and prices rise more slowly than expected, he might end up with a permanently lower standard of living.
Nor can pensioners know what the future demands on their income will be. The most probable pattern is V-shaped; high spending in the early years while they can still travel; a fall in spending as they become more housebound; and then a surge in spending in the final years to pay for nursing-home care. Given that these decisions are so difficult to make, it is sensible to give pensioners some flexibility. But that already existed.
No Briton was forced to buy an annuity until the age of 75. The danger now is that too few people will buy one, even with part of their money, although for some it will be the most sensible product.
There is another agenda at work here. One reason why annuities are so unpopular is that they stop pensioners passing on all their capital to their heirs. But pension saving is given a number of tax advantages: contributions can be offset against tax, no tax is paid on the investment returns and a tax-free lump sum can be taken at retirement. Even though the eventual pension income is subject to tax, this is often at a lower marginal rate than the pensioner paid while in employment.
Richer employees tend to have bigger pensions; in Britain, higher-rate taxpayers get half the benefit from pension tax breaks (the total cost is £35 billion, or $58 billion, a year). Allowing the better-off to pass their capital to their heirs hardly seems a fiscal priority in straitened times.
LET the pensioners free. That was the rallying cry of the recent British budget, which decreed that those who accumulate a pension pot no longer must use the proceeds to buy an annuity on retiring.
The change will bring Britain into line with America and Australia, where those retiring have immediate access to their pension pots. But Canada, Singapore and Sweden still impose fairly tight restrictions on what they can do with their money, as do Denmark and the Netherlands, two countries with widely-admired pension schemes.
Many people believe annuities, which transform a pot of cash into regular payments until the beneficiary dies, are a bad deal. Certainly, the failure of Britons to shop around for the best rate when they retire (the so-called open-market option) means that some lose out. But the two main reasons why annuity rates have fallen are fundamental; first, people are living longer and second, the general level of interest rates has fallen.
Pensioners exercising their new-found freedom need to take account of both factors. In 1960 British males who reached the retirement age of 65 could expect to live a further 12 years; now it is almost 19 (and 21 years for females). The income from any given pot has to be lower because it needs to last longer.
Meanwhile, interest rates are low because central banks are worried about the health of the Western economies; thanks to deteriorating demography, we may have moved to a slow-growth, low-rate world.
Think of an annuity as paying the equivalent of the market’s risk-free rate. It is possible to earn a higher return than the risk-free rate but only by taking a risk; and people may underestimate the dangers. Suppose investors decided to put their entire pension pot into equities and to take an income of 5% a year; if the stockmarket fell by 40%, as it did in 2008-09, then half the pension pot would be gone within two years. Nor do equity markets necessarily rebound; the Tokyo stockmarket is still only a third of the peak reached in 1989.
Investors may also underestimate the costs of riskier investing. Annuity rates are net of fees but those who invest in a mutual fund may be subject to expenses and fees of 2% a year. Many people may prefer to invest their nest-egg in a buy-to-let property. But what if they pick a house on a flood plain, or a property where recalcitrant tenants cause substantial damage or refuse to pay rent for a while? Pensioners may then be stuck with an illiquid asset, with high repair bills and uncertain income.
The chart shows how many years a pension pot will last (on plausible rates of return), for various levels of income. Beating annuity rates (currently 6% for a 65-year-old male, or 4% with inflation-linking) is not automatic.
Of course, buying an annuity involves risk as well. The annuity purchase might occur at an unusually unfavourable moment. There is the risk, if the buyer opts for a fixed-rate annuity, that the income might be eroded by rapid inflation. Conversely, if the buyer opts for an inflation-linked annuity and prices rise more slowly than expected, he might end up with a permanently lower standard of living.
Nor can pensioners know what the future demands on their income will be. The most probable pattern is V-shaped; high spending in the early years while they can still travel; a fall in spending as they become more housebound; and then a surge in spending in the final years to pay for nursing-home care. Given that these decisions are so difficult to make, it is sensible to give pensioners some flexibility. But that already existed.
No Briton was forced to buy an annuity until the age of 75. The danger now is that too few people will buy one, even with part of their money, although for some it will be the most sensible product.
There is another agenda at work here. One reason why annuities are so unpopular is that they stop pensioners passing on all their capital to their heirs. But pension saving is given a number of tax advantages: contributions can be offset against tax, no tax is paid on the investment returns and a tax-free lump sum can be taken at retirement. Even though the eventual pension income is subject to tax, this is often at a lower marginal rate than the pensioner paid while in employment.
Richer employees tend to have bigger pensions; in Britain, higher-rate taxpayers get half the benefit from pension tax breaks (the total cost is £35 billion, or $58 billion, a year). Allowing the better-off to pass their capital to their heirs hardly seems a fiscal priority in straitened times.
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