Retirees need to be given more help on deciding on buying an annuity in later life, according to new research from pension consultants LCP.
Their analysis suggests many pensioners could get a better outcome by switching some or all of their savings into an annuity at a later point in their retirement.
The study – ‘Is there a right time to buy an annuity’ – points out that since the introduction of pension freedoms in 2015 most people choose not to annuitise at retirement. As a result annuity sales have slumped and the majority of new retirees either cash out their pension pot in full or move it into a drawdown account to support them through retirement.
However LCP says that while annuities may look poor value to those in their early 60s this may not be the case as people age.
According to LCP’s analysis, someone aged 60 who chooses drawdown is likely to be 10 per cent happier overall than someone who immediately uses all of their pension pot to buy an annuity.
But as the person gets older, the attractiveness of an annuity increases. It found that on average around the age of 67, the model predicts that the retiree would be happier overall with an annuity, and this effect gets stronger the older they get.
LCP’s analysis is based on modelling that takes into account more than 2,000 different scenarios for future investment performance and life expectancy. This also takes account of factors such as attitude to risk, ‘loss aversion’, and a desire to have funds at the end to pass on to heirs.
LCP says that a key result is that in all the different models tested there is still a ‘crossover’ point where annuities become more attractive, though the age at which this crossover occurs can vary. It found:
- If an individual is willing to take higher investment risk in their drawdown portfolio, the age at which an annuity becomes more attractive rises. For a 75 per cent equity portfolio, switching to an annuity makes sense at age 70 (compared with age 67 for a 55 per cent equity portfolio;
- If an individual is strongly risk-averse they should move out of drawdown sooner: at age 64 in the version of the model which gives a bigger negative weighting to downside risk, compared with age 67 in the baseline.
- A ‘hybrid’ approach where the individual uses part of their pot to annuitise at 60 and then annuitises the balance later in retirement can generate the best outcomes at all ages. In this case the ‘crossover’ point where the balance of the pot is annuitised would be around age 71.
As the paper explains, one reason why annuities become steadily more attractive is that the uncertainty of life expectancy grows as people get older. In simple terms, it becomes steadily harder to manage the balance of your pension pot in later life in order to make sure you don’t run out of money prematurely or live more frugally than is necessary.
These results raise questions about how the large number of people who have gone into drawdown under pension freedoms might be prompted to reconsider this decision in later retirement.
LCP suggests with a mid-retirement ‘MOT’, similar to the mid-life MOT currently being piloted. It also suggests a need for drawdown products which ‘default’ individuals into an annuity at a later age, although suggests these should have the safeguard option to change this decision if circumstances change.
LCP partner and co-author of the paper Steve Webb says: “Whilst forcing people into annuities in their late fifties and sixties was not the right approach, it would be wrong to write-off annuities altogether.
“This research shows that for a wide range of people there could come a point during retirement when a switch to an annuity gives them better outcomes overall. Policy makers need to think how best to nudge people to review their finances not just at retirement but during retirement”.
Phil Boyle, co-author, and partner at LCP adds: “The exact point at which an annuity becomes more attractive depends very much on the individual. Our model suggests that for a wide range of people there is an age beyond which staying in drawdown may not generate the best results.”