A pension annuity is part of a generous UK tax regime
Generous, Government, tax…not a combination you’d expect. However, pension annuities are an integral part of a generous UK pensions tax regime. On balance it is perhaps therefore not unreasonable for the Government to expect annuitisation of 75% of the fund, i.e. after the 25% tax free cash element.
The benefit of annuitisation at age 65 is relatively small. The chance of dying at age 65 is less than 1%. An annuitant receives a mortality cross subsidy of less than £500 in that first year for putting £50,000 capital at risk. This is not very attractive and does not lead to a significant increase in lifetime income. Most pensioners would rather retain control of their capital.
As you would expect, as people get older so the benefits of fully annuitising grow exponentially and the impact of investment returns diminishes. Let’s delay annuitisation to 85…a male aged 85 deciding to annuitise today with no death benefit, the pension annuity would provide a guaranteed income of around 20% of the capital (healthy). The mortality cross-subsidy overshadows any investment return, so fixed pension annuities with their bond investments increasing, become the optimal solution.
It is not a question of if but when pensioners should fully annuitise; remembering that this is not necessarily when the pension annuity is first purchased. Pensioners need a retirement annuity account which limits the fund at risk in early years but retains mortality cross-subsidy in later years to provide the essential longevity insurance.
Pension annuities have a central role as part of any retirement income plan and offer the most effective and economic way of maximising lifetime income, with a guarantee.
Pensioners using income drawdown as an alternative to a pension annuity are exposed to a number of risks:
- they risk outliving their capital, or more likely having to reduce their income as they get older
- they are exposed to investment risk such as drawing down income when markets are depressed, which can have a significant impact on overall income levels
- they are exposed to the risk when they decide to purchase a pension annuity
- they expose themselves to ‘mortality drag’ and the risk that mortality improvement assumptions will be strengthened by the time they come to switch to a pension annuity.
Of course these risks can work in a retirees’ favour, but the key point is that only those who can afford to take these risks should do so. Given the lack of adequate pension savings this is unlikely to be a majority. This backs up the point that pension annuities are likely to be the right choice for the majority of people reaching retirement.