Annuities: What’s so bad about a guaranteed income for life?

This guest post is by Mark Meldon, an independent financial advisor (and Monevator reader!) who we’ve noticed talking a lot of sense over the years.

With more and more Baby Boomers reaching retirement, I thought I’d mount a defence of the much-maligned annuity as a solution to the question of after-work income.

As an IFA, I have seen a big increase in the number of enquiries from individuals wanting annuities rather than ‘flexi-access drawdown’ this year, and I think I know why.

But first, a little bit of history.

A serious business

…but if you observe, people always live forever when there is an annuity to be paid to them; and she is very stout and healthy, and hardly forty. An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it.

– Jane Austen, Sense and Sensibility (1811)

What Jane Austen said over 200 years ago is still quite true today. Those who purchase a guaranteed income for life via an annuity – whether through using their pension fund to do so or, much more rarely, by spending their own money – tend to enjoy better-than-average health and suspect that they will live for a long time.

Otherwise why would they do it?

They also appreciate something often misunderstood by most of the population – you will live longer than you think, unless you are very unlucky.

Nowadays, even those suffering poor health or making poor lifestyle choices – smoking is an obvious example– can get recognition for their reduced life expectancy with underwritten annuities.

Annuities have been around in one way or another since Roman times and were very popular following the founding of Equitable Life in 1762 and the establishment of hundreds of competitors in the centuries that followed. Even the government sold annuities up until 1928.

Back in the 1970s and 1980s, there were well over a hundred life offices arranging annuities¹. Now just a handful remain – we will see why that is a little later!

So, what, exactly, is an annuity?

Upside down life insurance

One way to think about annuities is that they are the reverse of a life assurance policy.

If you buy a life assurance policy you make small regular payments to your life office and, should you unfortunately die during the term, they send you a big cheque.

The reverse is true with an annuity. Here you send the life office a big cheque and they send you little bits of money until the day you die.

Most annuities are fixed in payment, but those that increase by a fixed percentage (‘escalation’) or by reference to the RPI (Retail Prices Index – a measure of inflation) are available and are a sensible choice if you can afford one.

We can see, therefore, that an annuity insures the annuitant against longevity risk, because of the guaranteed lifetime income stream.

You simply don’t get that with any other kind of investment – period.

I have arranged hundreds of annuities over the years, nearly all of them pension-funded ones. I can honestly say that nobody, ever, has been unhappy with the annuity. These individuals were not fazed by the ‘annuity puzzle’.

The annuity puzzle

In recent years, lots of economists have spent a great deal of time wrestling with what they like to call ‘the annuity puzzle’.

This so-called puzzle was first drawn attention to by Franco Modigliani in his Nobel Prize acceptance speech in 1985.

Modigliani said:

“It is a well- known fact that annuity contracts, other than in the form of group insurance through pension systems, are extremely rare. Why this should be so is a subject of considerable current interest. It is still ill-understood.”

What Modigliani said a third of a century ago remains true today.

According to Shlomo Benartzi, Alessandro Previtero, and Richard H. Thaler²:

‘Rational choice theory predicts that households will find annuities attractive at the onset of retirement because they address the risk of outliving one’s income, but in fact, relatively few of those facing retirement choose to annuitize a substantial portion of their wealth.

Adding some behavioural factors only deepens the puzzle because annuities have the potential to solve some complex problems with which individual struggle, like when to retire and how much they can spend each year in retirement, and thus they might be expected to be attractive for that reason as well.’

Benartzi, Previtero, and Thaler go on to say something very important and relevant to today’s ‘at retirement’ sector:

‘In addition to these arguments based on rational choice theory, certain behavioural factors should, in principle, increase the attractiveness of annuities.

As a first approximation, middle-class American households spend what they make. Whatever saving takes place occurs via pensions and paying off home equity, and the latter vehicle seems to have become much less fashionable in the last decade.

If the primary income earner in a household retires, the ‘spend what you make’ rule of thumb is no longer available. Instead, households who choose not to annuitize must learn a new skill, namely calculating the optimal drawdown rate over time.

Given the complexity of this optimization problem, it is not surprising that retirees might err, either by under-or overspending. These errors can easily be exacerbated by self-control problems if households have trouble sticking to their drawdown plans, either by spending too little or too much.

By converting wealth into an annuity, individuals and households can simultaneously answer the conceptually difficult question of figuring out how much consumption is sustainable given the age and wealth of the consumer and provide a monthly income target to help implement the plan.’

I like that – a lot! This is, after all, exactly how ‘defined benefit’ (aka ‘final salary’) pensions and our state pension works – a guaranteed income for life, with some inflation proofing, too.

They can give a ‘baseline income’ covering regular bills, and other pension funds and investments can cover other expenses as they arise.

So why are annuities still so unpopular?

Annuities are not at all sexy. They are also very much a one hit wonder as far as IFA and financial services companies fee-earning ability is concerned.

Nor can they help the reckless squander their capital!

Not so long ago I was at a conference concerned with the ‘at retirement’ market. The speakers produced various tax-planning tips, observations on the state of the investment markets and several technical sales techniques, and how much money they were making ‘managing the Baby Boomers money’. Whilst all this was very impressive in its way, and undoubtedly some of the ideas promulgated might work in certain circumstances, I did find the whole day rather discomforting.

When asked, I said how ridiculous it was that the retired had to spend so much time thinking about their investments, taking and paying for advice, and worrying about the stockmarket. I said I thought that for many it would be much better to cover their financial backsides with a lifetime annuity.

A couple of the presenters seemed to question my views and suggested some naivety on my part.

As I trudged across the rain-swept car park I wondered who was right.

Was it them with their discretionary fund management offerings, index funds managed by algorithms (what?), venture capital trusts and offshore investment bonds? Sure, these things can be useful in certain situations, but they all involve risk, sometimes very substantial risk.

Perhaps my line of thinking about how best to secure my clients a decent amount of worry-free lifetime income with at least some of their wealth is rather old-fashioned, but I remain convinced that it has its place for many people.

A 19^th Century digression

I need to mention here another long-dead novelist, Anthony Trollope, who was writing his Palliser series of novels about 50 years after Jane Austen wrote Sense and Sensibility.

Since the turn of the year, I have been re-reading these great stories at bedtime – I’m about to start Phineas Redux – and something struck me related to my work.

Trollope’s middle and upper-class characters are always banging on about how much money they have, but, in contrast to the IFAs I met at that Exeter conference, their 19^th century fortunes are almost always described in terms of the annual income they produce, not the lump sum.

It seems to me that hardly anybody talks about investments that way now. It’s all about net worth and asset value. I do wonder if asset values have come to play such a big role in modern financial life that we’ve forgotten what those assets are for?

In Trollope’s world, people bought shares purely for the dividend. Now dividends are usually an afterthought, with price appreciation the main goal.

I think that is wrong-headed.

Annuities don’t buy Aston Martin’s

I took a call in my office the other day from a lady seeking help with a pension sharing order following her divorce.

She didn’t appreciate that she won’t be getting a pension when it goes through. She will get an investment account wrapped up in a pension, unlike her ex-husband, who will continue to receive half his indexed-linked final salary pension. This lady was very shocked to learn that she must think about investment, interest rates, longevity statistics and all that kind of thing when her ex doesn’t.

I suspect that she might well choose to annuitise part of her eventual fund in a year or two, as she did understand the guaranteed income for life bit of our discussion.

Yet this lady also helped confirm what I thought was merely an urban myth. A close relative of hers took a transfer out of his employer’s final salary pension scheme just past age 55. He then cashed-in the whole lot – paying away almost half the fund in tax and losing his personal allowance – and blew £160,000 on an Aston Martin DB11.

I said that was completely crazy and she agreed. Apparently, the gentleman enjoys good health, but he sure is going to be income poor when he is 80.

I have no reason to disbelieve this story.

So, what to do when it comes to annuities?

I recommend you think hard about all options when you are nearing retirement and looking at your investment choices:

• Consider annuities very seriously.
• Maybe mix and match annuities with other financial arrangements.
• Conventional annuities are certain! Nothing else is. There are investment linked annuities around, but these are not ‘certain’ in the same way.
• Annuities don’t cost much to arrange. An IFA will charge to search out the best deal and to set one up – but there are no ongoing fees to pay, as far as the annuity purchase itself is concerned.
• Most annuities involve no investment risk.
• If you think you will live forever, an annuity is a great idea.
• If you think you will die soon, think hard about not buying an annuity.
• Final salary pensions are, in practice, annuities.
• So is the state pension.
• You can use ‘flexi-access drawdown’ as the icing on the cake – but remember it isn’t guaranteed and it costs a lot to run.
• You say you don’t want an annuity? But do you really want to be invested when you 90 – or a landlord with a portfolio of buy-to-lets?
• Remember inflation. Even today, with inflation quite low in historical terms, rising prices quickly erode the purchasing power of a fixed income. You can purchase annuities that increase in payment by a fixed percentage – usually with a maximum of 8.5% per annum – or index-linked annuities that are referenced to any increase in the RPI. In many ways, an index-linked annuity would be ideal, but they are very expensive, often reducing the ‘starting’ income compared with a fixed annuity by around 50%.
• If you are worried about dying sooner than average – and thus subsidising those who live longer than average – consider a life assurance policy for your financial dependants
• Don’t arrange a single-life annuity if there is someone else financially dependent on you
• Finally, annuities offer something priceless – peace of mind!

Mark Meldon is an Independent Financial Advisor based in Cheddar, Somerset. You can find out more at his company website. You can also read his other articles on Monevator. Let us know in the comments if there’s a topic you think Mark could cover.

1. Source: UK annuity price series, 1957-2002, Edmund Cannon & Ian Tonks, University of Bristol & University of Exeter
2. Annuitization Puzzles – Journal of Economic Perspectives – Volume 25, Number 4, Fall 2011

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