How to have a secure retirement

Many people loathe annuities. But they're actually better products than many people realise.

I know that many people loathe annuities - including a fair number of lovemoney.com readers.

DP130132 is one example. Last year he commented:

“the annuity, you are obligated to buy, will probably  be the worst investment you have ever made!!”

And in 2009, MrRee said:

“The annuity companies have done their sums, they know what they are doing, they are not there to make YOU rich – but to pay themselves huge bonus payments.”

These two readers aren’t alone. So what are the products that inspire so much disapproval?

Basically, an annuity is a product that allows you to convert a capital sum into an income for your retirement. Let’s say you’ve accumulated a pension pot worth £100,000 when you’re 65. You could pay that money to an insurance company which would then give you an annual income. At current rates, that would be around £6,000 a year.

Now I’m not claiming that annuities are perfect. But I think they’re better products than many people realise. Even though the rules have now changed and you’re no longer obliged to buy an annuity, I reckon I probably will still buy one when the time comes.

So here are the reasons why I like annuities:

They pay out till you die

I went to a 100th birthday party last year and it really made an impact on me. Of course, I’d read articles about life expectancy getting longer all the time, but meeting a 100-year old lady really hit home. For the first time, I started to seriously think about the implications of living until I’m 100. I might be retired for 35 years!

Such a long retirement is going to be expensive. The best way to cope with that expense is to be super-rich. Failing that, an inflation-linked final salary pension will do the job nicely.

Sadly, I don’t have a final salary pension and I very much doubt I’ll ever be super-rich. The next best option is to build a pension pot and buy an annuity. That’s the only way I can be sure that I’ll have an income until I die. If I don't buy an annuity, there's a real risk that I'll run out of money at some point.

Stock market crashes won’t matter

I’m a great believer in stock market investment. The long-term returns are too attractive to turn down.

But when I’m retired, I want to be relaxed and not have to worry about what is going on in the City. Most annuities aren’t backed by shares and have no connection to the stock market. So when Jeremy Paxman starts a share price round-up, you can switch off immediately! 

Annuities can go up

When the time to comes to buy an annuity, you’ll have to decide what kind of annuity you want. The most popular type is the level annuity. This is where you’ll receive the same amount of money each year for the rest of your life.

People go for level annuities because they want the highest possible income when they first retire. However, if you’re prepared to accept a lower income initially, you can get ‘escalating annuities’ that increase by, say, 3% a year. Or you could get an index-linked annuity that rises in line with inflation. Then you’ll have even more peace-of-mind.

No more charges

Once you’ve bought an annuity, you’re not paying any further charges to the financial services industry.

However, if you go for the alternative approach of income drawdown, you’ll carry on paying charges to the managers of your investments.

Getting more popular worldwide

Annuity-haters sometimes say that the UK is the only country in the world that uses annuities in a widespread manner – this fact is then cited as proof that the whole system is flawed.

In reality, Britain isn’t on its own. Both Sweden and Chile have compulsory annuities while Singapore is moving towards compulsory annuities in 2013. What’s more, the Financial Times reported last year that the Obama administration is thinking about trying to encourage take-up of annuities in the US.

Downsides

I don’t deny that there are downsides to annuities. The rates offered by some providers are too low, so it’s essential that you shop around when you buy an annuity through brokers such as Annuity Direct. That way, you’ll get the best deal and you’ll hopefully keep a lid on the charges too.  

There’s also the risk that you’ll die shortly after you purchase your annuity. As a result, you and your family will get very little return from all your years of saving. That’s unfortunate, but this is the price you have to pay for the income guarantee. People who die shortly after purchase subsidise those who live to 90 or longer.

I think the biggest downside is what I call the ‘bond yield lottery.’ Annuity rates normally move in parallel with yields on bonds and bond yields have varied dramatically over the years. Back in 1990, a typical new annuity for a 65-year old man paid out around 15% a year. Now a new annuity pays around 6%. So buying your annuity when gilt yields are high can make a big difference. (In fairness, falling gilt yields aren’t the only reason why annuity rates have declined. Rising life expectancy has also been an important factor.)

When I get to 60, I will keep a close eye on what happens to annuity rates. I’m not expecting to retire at that stage, but I’ll want to watch the annuity market so that when rates are good, I’ll be able to nip in and buy.

The bond yield lottery is extremely annoying, but the fact that I can get a guaranteed income for life means that I’ll almost certainly buy an annuity when the time comes.

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