When people reach retirement, they often buy an annuity with the pension funds they have worked hard to accumulate during a working lifetime.
This financial instrument converts capital (the pension fund) into a guaranteed stream of taxable income for the rest of your life.
In a sense, it is an insurance policy against living for too long.
Because the insurance company will keep paying the annuity income for the rest of your life, the total you receive could be dramatically higher than the value of your pension fund.
You could get back a lot more than you paid in. The opposite is also true.
If you die sooner than expected, you stand to lose at least some of the value of your pension fund.
I noticed a tweet this morning from Director-General of the Saga Group, Dr Ros Altmann:
Annuity rates 5.4%: 65yrold man who dies before age 84 wont get his pension money back. No inflation protection, no interest
— Ros Altmann (@rosaltmann) December 17, 2012
At current annuity rates, a 65 year old man would need to live for nearly twenty years to see the total value of his pension fund returned as taxable annuity income payments.
The latest figures I have seen suggest that the typical life expectancy for a 65 year old man in the UK is 17.5 years.
If we were all average, buying an annuity would appear to be a financially foolish decision right now.
Unfortunately (or perhaps fortunately) we are not all average.
Despite very low annuity rates – which have been driven lower by very low gilt yields (as a result of the Bank of England asset purchase programme and other factors), rising life expectancy and greater solvency requirements for insurers – buying an annuity can still make sense for those reaching retirement.
Unlike the other available retirement income options, buying an annuity offers a high degree of certainty about future income levels.
Most people reaching retirement are simply not prepared to accept the risks involved with unsecured pension (income drawdown) or one of the so-called ‘third way’ retirement income options, which combine income certainty with investment risk and capital guarantees which introduce counterparty risk.
Looking solely at the numbers, you probably shouldn’t buy an annuity right now.
Once we move away from the theory and consider the reality of people reaching retirement age, buying an annuity is often the ‘least worst’ option.
What we can hope is that the Government, encouraged by lobbying groups like Saga, will recognise the current plight of those reaching retirement and do what they can to help.
In the meantime, seeking professional independent financial advice at retirement is essential to ensure that all of the retirement income options are considered in light of your individual circumstances, goals and objectives.
Getting the most competitive annuity rate at retirement, possibly by exercising the open market option, is only one small part of the retirement income jigsaw.
Do speak to us if you need to understand your retirement income options and make the best choice.
Photo credit: Flickr/Joe Shlabotnik
