Are annuities good for your well-being?
There’s evidence to suggest that annuities are a good choice for many people.
Many of today's retirees have the opportunity to live the kind of life they want to after decades spent juggling family and career demands. They also have much more freedom to use their pension savings how they like. Depending on the choices they make, they can keep their options open through retirement and manage their pension pot to meet specific goals that may change over time.
Yet, for many, the most valuable freedom will continue to be the ability to enjoy a reasonable standard of living in retirement without the risk of running out of money. The surest way of doing that is to convert pension savings into an annuity.
Annuities provide security, stability and a range of other benefits. They used to be the default option for those reaching retirement. Yet they have become much less popular in the UK since the introduction of pension freedoms. In its first figures released this year, the Financial Conduct Authority says between 10% - 15% of retirees are now selecting annuities, while 30% are opting for drawdown and 55% are taking full cash withdrawals.1
In the US, annuities remain deeply unpopular. This has attracted the attention of several prize-winning economists, one of whom even addressed the topic in his Nobel Prize Acceptance Speech. In 1985, Franco Modigliani pondered on the "annuitisation puzzle" and attempted to understand why they were so often shunned. He 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.”
More recently, behavioural economists Benartzi, Previtero and Thaler wrote that, “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 annuitise a substantial portion of their wealth."
Even today, the theory that many people will want to convert their pension pot into an annuity stands in sharp contrast to what we observe. So, why is this?
- Value for money
Although annuity rates have been improving recently, they are still low by historical standards.
- Lack of control
Many people prefer to be more involved in deciding where their pension savings are invested.
Even though annuity products may come in many shapes and sizes, income is generally inflexible and does not allow for changing needs and circumstances.
While an annuity will give you certainty, the income dies when you do, leaving nothing for your heirs.
- Underestimates of longevity
The Institute of Fiscal Studies has found widespread “survival pessimism” at all ages. This may make individuals reluctant to buy annuities, as they think that they will live shorter lives than they are statistically likely to. As a result, some retirees may ask: “Will I live long enough for this to pay off?”
Clearly, there are some drawbacks to annuities. They’re right for some people and wrong for others. But they have the potential to solve some complex problems with which some retirees struggle, such as how much they can spend each year. What's more, research suggests they can have a positive impact on well-being.2
Amongst those on modest retirement incomes, the number of people with drawdown plans who said they weren’t enjoying life was more than double the number of annuitants who expressed the same negative feelings.
The research also provided evidence that people with drawdown plans were finding it significantly harder to plan for the future.
This prompts the question: is there a correlation between wellbeing, planning and sense of autonomy and the retirement income choices that people have made?
The answer is far from clear. But the results suggest that thousands of people are potentially choosing options that are increasing their likelihood of feeling depressed in later life or unable to plan for the future.
What the research also demonstrates is the need for people to consider all options at retirement, and the importance of including annuities in these. For decisions as complex as accessing pension savings, individuals should seek advice. Without it, many may be taking out plans without fully understanding the risks.
1 Financial Conduct Authority, Sector Views, published January 2019
2 Demos research commissioned by Legal & General, November 2018