From Ros Altmann:economist and pensions,
    investment and retirement policy expert

  • pensionsandsavings.com

    To buy or not to buy – annuities are a gamble

    To buy or not to buy – annuities are a gamble

    Yes, not buying an annuity is a gamble, as is buying one!

    The attempts to defend annuity purchase are rather too simplistic.  Of course it is the case that not buying an annuity is a gamble, but what people do not yet realise is that buying one is also a gamble.  Customers need to understand that any decision around annuities is risky.  Currently, the industry and providers and even trustees seem to believe that buying an annuity is the ‘safe’, ‘low risk’ or even ‘no risk’ option.  This only applies to income and not to the person’s capital.  It’s all very well for providers to say that the capital doesn’t matter because the aim of pension saving is to provide a retirement income, however to the individual who is saving, the size of the pension fund capital does matter.  It is their money!  And those who buy single life annuities could well be leaving a partner with no value from their lifetime pension savings, while the insurance company pockets the rest of their money.

    Surely, the logic of the MGM analysis would suggest everyone should be encouraged to buy an annuity at the earliest possible opportunity.  On their logic, buying an annuity at age 63 would give you an extra 2 years of pension income and, indeed, buying at 55 would give you an extra 10 years of income from your pension, so why wait to 65?

    The reason, of course, is that age 63 or 55 may be too young, that it takes away the chance of earning extra returns, that your circumstances might change by the time you get to 65, that annuity rates might change, that inflation will eat away the value of your income, that you could die or become very ill.  If you buy an annuity at age 63 or 65 you are making a judgement on the probability of all these factors, when committing your money to irreversible annuity purchase.  The annuity protects you against living a lot longer than average.  There are other risks you need protecting against, however, which annuities fail to cover.  So whatever age you buy an annuity, the decision is a gamble on various outcomes.

    Here is an example of my alternative scenario to the MGM analysis.  Obviously, I am dealing in possibilities, nobody can actually predict the future, but that is exactly why any decision, whether to buy an annuity or not to buy an annuity is risky.  Both decisions are a gamble, they are just gambling on different things.

    Let’s take someone with a £100,000 pension fund.

    MGM say that a 65 year old today would receive a £5,900 single life annuity from that fund = an annuity rate of 5.9%

    A 67 year old today would receive £6165 from that fund today – an annuity rate of 6.15%

    If the 65 year old delays buying an annuity for 2 years (using the MGM example) then he would have foregone £11,800 of income (we will ignore tax for this calculation).

    The MGM analysis then assumes he still has a £100,000 pension fund in 2 years time and annuity rates have not changed.  So instead of receiving £5900 a year, he will get £6165 a year.

    So by delaying for 2 years the person ends up with an extra £265 a year (£6165-£5900).

    They then say that to make up for the loss of £11,800 income would take 44.5 years (£11,800 divided by £265).

    But this analysis ignores many vital elements.

    1.  The pension fund will not stay at £100,000 – the point of delay is that the fund has a chance to earn more return.  (Obviously there is a risk that the returns do not come through, but that is always the case with pension saving. The logic of the MGM view would actually drive you to say you should annuitise as early as possible, why not at age 55?, so that you don’t lose out on any annual income and don’t take any risk on the markets any more.  How long would it take to make up for ten years of lost income by delaying annuitisation to age 65 and would the investment returns overcome that?  Where do you draw the line!)

    So let’s assume that the pension fund grows by just 3% a year over the 2 years.  By age 67 the fund will be worth £106,090.

    If we then assume that annuity rates have not changed (the rate stays at 6.15% for a 67 year old), the customer will receive an annual income of £6,540 (£105,090 x 6.15%) instead of £5900, which is an extra £640 a year.

    Then to make up for the lost 2 years of income of £11,800 would take 18.4 years.

    2.  However, let us assume that the person develops a small health problem between age 65 and 67 (not uncommon, something like high blood pressure, cholesterol, minor impairment) and can then get a 10% enhancement to their annuity rate relative to the standard rate.

    That means their annuity rate at age 67 would be 6.78%.

    On their £106,090 pension fund, they would actually then receive £7193 a year, rather than the £5,900 that they would have got at age 65.  This is now an extra £1293 a year.

    In order to make up for the loss of the £11,800 that they would have received between age 65 and 67 (again ignoring tax) would only take another 9 years.  So by the time they reach age 76, they would end up with more money overall.

    3.  Now let us assume that annuity rates rise by 10%, rather than staying stable, and the person also receives a slightly enhanced rate as above.

    The new annuity rate would now be 7.58%.  On the higher pension fund of £106,090, this 67 year old would then receive an annuity income when buying at age 67 of £8,041 a year.  This gives an extra £2,141 a year.

    In this case, in just 5.5 years (i.e. by age 72) they will have made up for the loss of those 2 years of income and then have an extra £2,141 each year to live on.


    Buying an annuity is a gamble.  There are many variables to be considered.  Once you lock into an annuity, whenever that is, you have taken away any upside (assuming a standard type annuity with no investment linking or escalation).

    The customer needs to understand what the implications of buying at any one time are.

    Will I become ill?

    Will I earn some extra return before buying?

    Will inflation be a problem I should worry about?

    Will interest rates change?

    Will annuity rates change?

    What about my partner?

    Will I die very young and lose the chance to pass on my fund tax free?

    What age do I need to live to for this to be good value for me?

    Do I want to consider short-term annuities or guaranteed annuities?

    Buying an annuity is effectively deciding that you no longer want to have the chance for your fund to grow.  You do not believe your health will deteriorate further.  You do not believe you will die sooner than the insurer expects.  You cannot afford to delay the purchase of an income stream and keep your options open in case either your own or the market circumstances change.

    Clearly, there will be people who are comfortable with those decisions, and do not want to leave their options open, but many who buy annuities do not understand that they even have such options.  They are being frightened or encouraged into buying one financial product with all their pension savings without realising what other opportunities they have.



    One thought on “To buy or not to buy – annuities are a gamble

    1. In no way in this comment (or my previous comment on your blog) am I advocating or defending the compulsion of annuitisation. However, your constant myopic blog posts about the negative aspects of annuities are just as simplistic as the stylised defence of annuities.

      I believe that your intentions to highlight the issues with annuities to protect widows is admirable. But it is, again, your myopic approach that raises questions. Your examples of annuities use a very extreme scenario of a single premium, non-inflation linked annuity, solely bought by the male using both partners retirement savings, with no reversionary aspects.

      Further, do you advocate not purchasing home, or car or life insurance? Like any insurance, it is a gamble. Without any figures to hand, it would be reasonable to suggest most individuals do not ‘get back’ what they put into any insurance contract. Because, they are not an investments.

      It is also important to note what you’ve said about risk and annuities. Yes, an annuity does reduce or even eliminate risk around income. However, there are risks associated with capital and income by remaining wholly invested in the market. Sequencing risk could really affect a retirees capital base and income being generated from drawdowns on that capital. A person who before the Global Financial Crisis retired would have suffered considerable capital loss while also drawing down on their pension savings (further eroding that capital base and limiting the ability to recover the market linked capital losses). The point being, there are two sides to this coin.

      No doubt you raise some legitimate product design concerns with a certain type of annuity. However, the right annuity product, used as part of the retirement ‘toolbox’, through partial annuitisation can be very powerful in delivering better retirement incomes for most retirees.

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