Everybody hates them because they are associated with the compulsion of the pensions regime. But they have their place.
An annuity is.....
..... a dead simple idea. You pay a capital sum (or you accumulate a capital sum in your pension pot). In return you receive an annual income until you die. The annual income is called an 'annuity'. You have 'bought an annuity'.
The trouble with planning for death is you do not know when it will come. If, sensibly, you plan to spend all your money before you die you do not know how quickly to do it. An annuity passes that problem to someone else.
A standard annuity pays a fixed sum until death. But there are as many different varieties as there models in the Ford range. And for the same reason: every kink and tweak is an attempt to widen the market for the product. Here is a partial list. The market changes so frequently that it will probably be out-of-date by the time you read this:
- Payments can be inflated at a fixed rate
- Payments can be linked to the Retail Prices Index
- Payments can be linked to a stockmarket return
- Payments can be garanteed for 5 years even if the annuitant dies
- Annuities can be on joint lives - payments continue until you both die, often with a reduction after the first death.
Annuity rates are quoted in percent. Today (2019) a 65-year old healthy male can buy a standard annuity for about 5%. That means that if he pays £100,000 he will receive £5,000 every year until he dies. That sounds pretty good, when the best you can get on a savings account is 1.5%. But there is a catch.
You must remember that you never get your capital back. But with a savings account you do. And that makes a big difference.
We don't want to get bogged down in the maths here. So just take our word for the following, based on the above example:
- if he lives to age 85 his investment return is zero - he gets back what he pays out, no more
- if he lives to age 90 his investment return is 2.0% - that's what £125,000 over 25 years on £100,000 sent gets you
- if he lives to age 100 his investment return is 3.6%
These are not exciting returns. Against that, you've bought certainty - insurance, if you like. If you invest the £100K yourself, and the investment performs badly and you live a long time...........
Like so many savings decisions, only you can decide whether an annuity is right for you. Annuities got a bad reputation because the pension regime used to demand that you buy them whether it made sense for you or not. But that does not make them bad for everyone.
What you must do is treat annuities like any other investment. Do your sums, and evaluate them carefully against the other ways you might provide for your retirement.
Otherwise, with such a wide variety of annuities available it is difficult to give generic advice. But here are some things that you should watch for:
- Tax: Annuities derived from a pension pot are taxed as income. Annuities purchased with savings outside a pension pot (usually called Purchased Life Annuities) are partly taxed as income and partly treated as a return of capital (and therefore untaxed). The proportions depend on the product. Insist it is clearly explained to you.
- Cost: These are insurance company products, and therefore support a high level of spend on marketing and commissions to financial advisers. You are paying for that.
- Inflation:...will erode the spending power of your fixed annuity. You can buy more complex annuities that try to address this, but....
- Complexity (1): When you go to a car showroom to buy a bog-standard family car a good salesman will send you out of there with special wheels, 16-valves and all sorts of stuff that you did not realise you needed. Because that is where his profits are made. Annuities are the same.
- Complexity (2): When you trade in your old banger for your new car the salesman will always try to quote a net price for the deal. Because he knows that he is likely to make a better trade than if he disentangles the deal into separate prices for the new car and the old. It's the same for annuities.
- Inflexibility: Annuities are irreversible.
- Supplier risk: If your insurance company goes under, so does its promise to pay your annuity. Heed the warning of Equitable Life. Your investment return must include a risk premium.