Case study: Pros and cons of annuities for a £150,000 retiree pension pot 

Since the turn of the year UK annuity rates have risen significantly and appear likely to continue rising as the Bank of England grapples with mounting inflationary pressures, says Christine Hallett, managing director of Options UK.

This trend puts annuities firmly back in the retirement income planning picture, but it has also created a potential headache for advisers and their clients. Do they adopt a traditionally cautious or a much riskier approach to retirement income? In other words, do they rely upon an insurance company or equity investments to provide a reliable income in retirement? 

The most common question asked of advisers is: "If I buy an annuity, will I get my money back?" It's impossible to answer because no-one knows when they will die; an annuity is a financial gamble, but is it as much of a risk as staying invested and drawing down a pension from a DC pot?

To help advisers understand some of the pros and cons we asked Options For Your Tomorrow (the independent pensions provider which is part of STM Group Plc) to consider a hypothetical scenario in which two 66-year-old male retirees each have a pension pot worth £150,000.

Retiree A

He wishes to draw down from his DC pension. He expects to achieve net returns of 3.5% and increase his income by 2% every year, starting with an annual income of £9,600. If we assume returns remain unaltered by the time Retiree A reaches the age of 83, his annual income will have grown to £14,481 and he will have withdrawn £203,578 from his pension. Unfortunately, by that point, he will have run out of money. 

Retiree B

He uses his £150,000 pension pot to buy a single-life, level term annuity with a 10-year post-death income guarantee for his spouse. He suffers from high blood pressure, which the insurance company issuing the annuity has taken into account. Retiree B's annual fixed income is £9,289, which means he would recoup his original £150,000 investment within 16.1 years and the annuity would continue to pay him this amount until he dies. 

At first glance….

This may appear to be straight-forward case of an annuity offering better value than drawdown. However, while it may appear to provide peace of mind, account must be taken of inflation, from which Retiree A is at least partially protected, whereas Retiree B's real income will be affected by inflation's corrosive impact. 

So drawdown ‘wins' the retirement income argument? 

Not quite, for Retiree A must be wary of ‘sequence risk', i.e. the possibility that the longer-term order of investment returns will prove unfavourable.  

There is a very strong correlation between investment returns achieved during the first decade of retirement and the level of income over the following 30 years. Accordingly, should Retiree A achieve steady, positive returns during the preliminary stages of retirement, statistical evidence suggests he will not run out of money.

Sequence risk can affect anyone taking the same option as Retiree A. 

Simply assuming that a net return of 3.5% and an inflation-adjusted withdrawal rate of 6% is achievable over three decades verges on the foolish as it would have failed almost 50% of the time during actual scenarios over any 30-year period between 1900 and 2016.

Food for thought

As annuity returns have risen, so too have product sales. As Christine Hallett (Managing Director of Options UK, the business behind Options For Your Tomorrow) notes, this trend is being driven by several key advantages that annuities offer. "In addition to peace of mind," she says, "annuities now offer competitive returns and a form of insurance against longevity."  

She also highlights the advantages offered by the flexibility of some annuity products which provide additional benefits when compared to a standard, traditional annuity. For example, some flexible annuities are designed to provide tax efficient, regular income payments for life or until the assets in the portfolio of funds are exhausted. The income payments may be taken monthly, quarterly, half-yearly or yearly - and some products offer the additional flexibility to change the income payments once the annuity is in place. 

In summary, selecting the most appropriate form of retirement income is a gamble, and one which can clearly have significant repercussions lasting many years.