This is one of a series of 8 chapters which we hope will stimulate thought around the difficult issues that people may face while investing in retirement. Spire Platform Solutions does not provide advice and does not advocate any particular investment solutions.
More people than ever before are now faced with the choice of annuity or drawdown as rising numbers of pension savers with a worthwhile period of saving in DC schemes, approach retirement age. And for the wealthier amongst this cohort, it’s no longer a binary choice. Instead, they may be weighing up how to balance both an annuity and an income drawdown plan within their retirement income portfolio
In Chapter 3 we looked at how people underestimate longevity, and fail to appreciate that half of us will live longer than our life expectancy. For these people, the annuity just carries on delivering. However, it’s precisely in this period that a corporate bond portfolio can be ravaged by the hazards of duration risk, reconstruction risk and default risk that we discussed in Chapter 1.
When death occurs, the annuity stops paying, and we can then calculate the average annual rate of return that the annuity delivered to its holder over the whole period from purchase to final payment. Of course we don’t know what age the purchaser will die at, so we’ve constructed a table to show the rate of return achieved to each potential age of death.
For the calculations we have taken the annuity rates offered by Just Retirement in December 2019, for a 60 year old using £100,000 of their pension pot to buy a single life annuity. They are assumed to be in average health and to live right in the middle of England, in Solihull. We have looked at both smoker and non-smoker rates.
Two things leap out at us from this table. Firstly, the saver needs to reach age 83 to get their money back, and interestingly 84 is current life expectancy for a healthy 60-year-old male. Secondly, provided the saver reaches age 87, then their investment return will exceed the reversionary yield available on a comparable gilt, which is 1.1%. And if they live to their early nineties, they will earn double the return available on gilts.
Because a smoker receives a higher annuity rate, their average return on their investment will be a little higher for the same age at death, although if they read the warnings on the side of the cigarette packet they will know they are less likely to achieve these ages!
It is important for the annuity purchaser to appreciate that if they die earlier than age 83, as the total payments will have been less than the purchase price, their average return will have been negative and they will have lost money. But if they hold both some annuity and some corporate bond funds in their retirement income portfolio then they can cover both bases, with the corporate bonds delivering a pay out on early death and the annuity delivering high returns if they exceed their life expectancy.
Age 60 is quite a popular age for early retirement, amongst those with sufficient assets in their SIPP to afford this. But let’s also look at the position for an annuity purchased at age 70, either because of a later retirement or simply a choice to defer annuity purchase to an older age.
Even though an older saver gets a higher annuity rate, our 70-year-old purchaser will need to live until age 87 to get their money back, compared to age 83 for the 60-year-old purchaser. (For the smoker, a 70-year-old purchaser will need to live until age 85 to get their money back, compared to age 81 for the 60-year-old purchaser).
This is another manifestation of the phenomenon also known as mortality drag i.e. the penalty for missing out on the early deaths of the other lives in the annuity pool. Contrary to what you might read in the popular press that insurers pocket the proceeds from those who die early as profits, what actually happens is that insurers re-distribute this money to those who are still alive.
The message from the numbers is clear: the younger you purchase an annuity, the sooner you will start to see a positive return on that investment. And the older you live, the better you will do compared to those purchasing a gilts or fixed interest fund.
I like to say that an annuity is like a fine wine: the longer you hold it for, the better it gets.
By Adrian Boulding - Chief Innovation Officer at Spire Platform Solutions.