The 19th of March 2014. The day George Osborne, then Chancellor of the Exchequer, announced a range of radical reforms to the UK’s retirement planning regulations.
This was captured succinctly by the soundbite of “let me be clear. No one will have to buy an annuity.”
Prior to the Budget announcement of these changes, quarterly sales of annuities averaged around 83,000, with around 11,500 on average using income drawdown. Immediately following the budget, as we can see in the chart below, things changed dramatically.
Gareth HopeHead of Research
In the eight-years since that Budget, the quarterly average for annuities has fallen to around 15,000, with income drawdown increasing to around 43,000. Income drawdown for the uninitiated is when amounts are taken from the overall pension pot (drawn down) with the rest staying invested in the markets. The advantages versus an annuity are that in periods of prosperity and market growth, the remaining pot continues to grow, potentially providing a higher level of income over the life of the investment, conversely the opposite would apply in periods of falling markets and recession.
This shows the scale this one ‘simple’ proclamation by the Chancellor has had on the retirement income planning of millions in the UK.
These changes also coincided with a period of low interest rates, which reduced the perceived value of annuities in purely financial terms, at a time when drawdown plans, which remain invested, saw a period of increased growth.
Times are changing though. Governments across the Western world are battling to keep inflation under control. We’ve seen the US Federal Reserve, the Bank of England and the European Central Bank all raise interest rates, which has caused bond markets to fall in value.
In the UK, we are seeing inflation at 40-year highs, with predictions of even higher levels in the coming months. With the most recent figures (August) showing the Consumer Price Index (CPI) being up by 10.1% over the previous year.
Generally, Central Banks have one tool to try and dampen rising prices – raise the interest rate. It is a fairly blunt tool all told; trying to incentivise people and businesses into saving (or at least not borrow) money rather than spending it, cutting demand, and hopefully leading to a fall in increasing prices.
Central banks raising interest rates has the knock-on effect of increasing the interest rates (also called yields) of the borrowing of the Government (gilts in the UK) which act as the benchmark of annuities.
The increase in gilt yields over the past six months particularly have seen a corresponding increase in annuity rates now back at levels around when George Osborne stood at the dispatch box.
Effectively, you can get more for your money in the annuity market than you could have done in the past six or so years. On the flipside, you need it as the cost of living has increased, but the difference now is that it is harder for drawdown to significantly outperform the annuity and in a period of volatility, the emotional benefit of guaranteed income starts to become more important for people.
However, we don’t know how long this period of increased inflation is likely to last, nor the extent to which the central banks will have to raise the underlying base rates.
We’re currently seeing central banks trying to walk the tightrope between tackling inflation and avoiding a recession. Compared to the past decade, we are seeing more volatile markets across and within a range of assets.
What has persisted however, is the view that annuities are ‘poor value’ and remove future choice.
I can certainly understand the last part of that – we all like choice. However, for me it misses a key part of the annuity – the offer of a guaranteed income for life. In this effect an annuity is not an investment in the same way as a pension in income drawdown is, it is an insurance against running out of money later in life.
An annuity won’t make you rich, but it might stop you being poor and that can be a powerful message for many people.
Retirement Income structure
As part of our work with clients, we look to break income needs down in to three buckets.
- Choice – Extra expenditure for those infrequent or unexpected one-off events or purchases
- Independence – Discretionary expenditure (to thrive) – income needed for their chosen lifestyle
- Security – Essential expenditure (to survive) – the minimum needed to fund basic household and lifestyle costs
Your ‘Security’ income is the essential income needed to meet your ‘basic’ lifestyle expenses. What classifies as ‘basic’ for one person will be different to the next, but this can be seen as a your ‘Minimum Income Requirement’ and should be protected as best as possible against future risks.
It may well be that this security is provided by the State Pension, which increases each year and provides at least some protection against inflation. For others, it may be that while much of this amount is covered by the State Pension, there is more required, and this is where annuities can have a part to play.
Shades of grey
As with so much in life, there is no ‘easy’ answer to the question – “what is best for me?”. In the same way, you do not have to make an all or nothing decision on the use of annuities within your retirement income planning. Wren Sterling uses cashflow planning tools to try and predict how long money is going to last in different scenarios and this can result in a blended strategy, combining access, security and investment growth.
You can use part of your pension to buy a guaranteed income for life to cover any shortfall towards your ‘security’ level of expenditure, and then retain the rest within income drawdown, retaining the flexibility and choice on this portion of your pension.
Ultimately, what we can all do is plan based on the information we have available to us today, make the best decision we can from that position and then manage the consequences of that as new information becomes available.
This is where the value of an ongoing service with your financial adviser really comes into its own. A client that took one-off advice a year or two ago is now in a very different macroeconomic place and it is highly likely that recommendations would change now in order for them to achieve their overall goals.