If you recommend income drawdown for your client then you will be in good company. The latest data from the FCA for the year to March 2020, shows that annuity sales continue their steady decline, with less than 70,000 contracts sold. That’s telling us that of the people accessing their pension pot for the first time, only one in 10 now buy an annuity.
In recommending the funds to hold inside the drawdown policy, you will take careful note of the client’s risk appetite and their potential to absorb losses if prices fall. It’s a well-trodden path which you will be very familiar with. For clients where a high proportion of their expenditure is on essentials, their portfolio will include a lot of low-risk funds.
However, are low-risk funds the best way to secure a sustainable retirement income? And how does purchasing an annuity stack up against them?
A game of two halves
The issue can be broken down into two parts. The first is whether the annuity will deliver good value to your client. The second is the impact that adding some annuity into a client portfolio can have on the fund selection for the assets that remain within drawdown.
Now if we were a financial regulator wondering whether an insurer is delivering good value to its annuity customers, we would look at their whole book of business. This has been visited many times, and the seminal paper is probably the one that the DWP commissioned from the two academics, Edmund Cannon and Ian Tonks in 2005, entitled ‘Survey of Annuity Pricing‘. They found that, although pricing does vary a bit from year to year, the historical norm is that an annuity purchased for £1 actually delivers £1 worth of value to the population of annuity purchasers.
However, I believe of greater interest to your client is the value that the annuity will deliver to them. This will depend upon how long they live for. The mortality cross-subsidy inherent in an annuity means that those that die early get back less than they paid in, while those that live beyond life expectancy will get back not only their own money but also a share of all those who passed away before them!
A simple way to show this is to look at the rate of return that your client will receive over the rest of their life if they purchase an annuity. To do this, I have broken down an annuity rate I obtained from the Money and Pensions Service website for a female aged 65 in average health and location. For a £100,000 investment, it provided an income of almost exactly £5,000 per year.
My starting point is the client’s life expectancy. Actuarial tables from Office for National Statistics show that a 65 year old woman has a 50% chance of living to age 87. For that date of death, the annuity yields an investment return of 2.1% per annum. By that, I simply mean that if instead of buying an annuity, the client had invested her £100,000 in an asset yielding 2.1% per year interest and had drawn down £5,000 annual income, then her investment would have been exhausted on her 87th birthday.
The yields get higher with increasing age, and compare very favourably with the redemption yield from a gilt of the same term:
|Client has a||Term (years)||Annuity yield||Gilt yield|
|50% chance of living to age 87||22||2.1%||0.66%|
|25% chance of living to age 94||29||3.9%||0.86%|
|10% chance of living to age 98||33||4.4%||0.87%|
The yields are positive because these figures are for life expectancy and beyond. The picture is, of course, different for those that sadly die early, and for this case, death before reaching age 85 returns a negative yield for the annuity.
Having demonstrated that if the client lives to or beyond life expectancy, the annuity will deliver very attractive yields compared to low-risk investments, we turn to look at the impact of adding an annuity to a client’s investment portfolio.
Clearly, the annuity is a low-risk asset. So, it can replace some of the other low-risk assets in the drawdown basket, meaning that the remaining assets can, on average, be higher risk. And higher risk means higher expected returns!
Sadly, the tools required to make the above calculations are not yet readily available. Advisers will be familiar with blending funds together. Tools exist to allow you to choose a basket of funds, some with risk ratings a little higher than the client’s tolerance. These can then be mixed with some funds with a risk rating a little lower than tolerance, so that on average the basket correctly meets the client’s risk requirement.
However, the tools struggle when you ask them to rate an annuity. Because they are using capital loss as their yardstick, when in fact for a pensioner it is income loss that is the crucial factor. The annuity will expend all its capital – that’s the nature of the beast – yet its income is doubly secure. First, it’s guaranteed by the insurer. It’s also fully-backed up by Financial Services Compensation Scheme should the issuer stumble.
I argue this is zero risk. So, if the rating tool you use doesn’t have a risk value for an annuity, then give it the lowest value the tool allows, and you will still have erred on the side of caution.
Not only is an annuity good value in its own right, but it also improves the overall value of the assets you blend it with.
Adrian Boulding is chief innovation officer at Spire Platform Solutions