Introduction
With recent improvements in headline rates, we often read of how annuities can help to provide a sustainable retirement income when combined with drawing down on investments and pensions, helping to mitigate sequencing risk. Let's jump right in and look at the data.
Disclaimer
Retirement planning is specific to an individual and includes deciding whether to purchase an annuity.
In this blog, we will be deliberately ignoring:
Health issues which can improve the annuity offered
Investor misbehaviour for the non-annuitised part of the retirement plan. Misbehaviour should not be underestimated, as it can decimate a retirement plan.
and focusing solely on how an annuity offered at standard rates impacts the sustainability of the retirement plan.
Brad Wesley
Brad Wesley is turning 60 and is thinking of finishing work. He has £1,000,000 to fund retirement and plans to spend an inflation-adjusted £40,000 per annum. Similar to David and Samantha in our 4% "rule" analysis, we will be making the following assumptions:
He will not receive a state pension;
Taxation and taxation optimisations are ignored;
He does not plan to gift or leave a legacy;
He is not expecting any inheritances;
He does not want to plan for potential care home fees;
He is not planning to downsize;
He is keeping expenditure assumptions simple.
Brad is considering two options:
Invest the £1,000,000 into a portfolio containing 60% (£600,000) equities and 40% (£400,000) bonds.
Replace the proposed bond investment (£400,000) with an annuity. The remaining funds (£600,000) will be invested into 100% equities.
Let's now look at how each option fares.
60/40 portfolio
For the 60/40 portfolio, Brad will be invested as follows:
36% developed market equity
12% developed market small-cap value
12% emerging market equity
40% global bonds
This portfolio will be familiar to you if you have read some of our other blogs, including "Should your retirement portfolio contain 100% shares?" Fees total 1.2% per annum (including advice).
We assume Brad lives to 96, at which point he has a 10% survival probability, according to Timeline. The balance is £1.31m in real terms for the median case.
100% equities with an annuity
The £600,000 not invested in the annuity will be invested as follows:
60% developed market equity
20% developed market small-cap value
20% emerging market equity
We will refer to the Hargreaves Lansdown Best Buy table* for the annuity.
*Hargreaves Lansdown is one of many best buy tables that are available, and it's not our recommendation to use this particular one! Seek advice about your specific circumstances.
For a single life, level annuity (payment not increasing with inflation), Brad can purchase an annuity paying £25,720 (4x£6,430) a year. Level annuities are currently the most popular option, representing 82% of annuities sold in 2023, according to ABI. Escalating annuities (offering various levels of inflation protection) make up the remaining 18%.
Fees for the remaining £600,000 are slightly higher at 1.5% per annum (the adviser and platform fees increase in percentage terms).
The median outcome, at £2.76m, is over twice that of the 60/40 portfolio.
The annuity approach works!!
Father Christmas is not real!
There are some disappointments that many of us remember in life. For many, it is discovering that Father Christmas is not real. For others (or maybe it's just me!), it's realising that widely accepted retirement planning approaches (cash buffers, withdrawal rate guardrails - the list is growing) don't hold up to more detailed analysis.
At Pyrford Financial Planning, we place more weight on less favourable historical outcomes as we want our clients to have the confidence to spend their money enjoying retirement, knowing that they have a robust plan in place.
Taking the historical worst case for the 60/40 portfolio, we see that the money runs out at age 85.
The worst case for the "100% equities with an annuity" alternative has the money running out at 76, almost a decade earlier! (Of course, there will still be the annuity income to fall back on, but as demonstrated below, in inflationary times, the purchasing power can quickly diminish.)
Why is there such a difference? The worst-case historical outcome has the retiree finishing work in 1969. This was just before the brutal inflation in the 1970s.
Using the Bank of England inflation calculator, we can see that inflation averaged 11.4% over the next decade, with prices almost tripling.
The purchasing power of the annuity will be far less as time progresses. The equity component of the retirement plan has to take up the slack. We can see this in Timeline, with £32,400pa (£281,600 cumulative withdrawal at age 71 versus £249,200 at age 70) having to come from Brad's portfolio ten years into retirement.
The annuity, which started at £25,720, now contributes less than £10,000 annually to the retirement pot!
What if we ditch the annuity?
We recently discussed why holding 100% equities in retirement is probably suboptimal for many retirees. However, let's see what would happen if we removed the annuity - 100% of the retirement funds are now invested in equities. The median case has a balance just north of £5m, with the worst case having the money running out at 82. Both are better outcomes than the blended annuity option.
Conclusion
Based on the above, we'd struggle with how adding an annuity would improve outcomes for our imaginary client. Of our three scenarios, it has the worst worst-case outcome while offering less upside than the 100% equity approach. As with many things in retirement planning, it's worth diving into the worst-case historical outcomes to understand where the skeletons might lie. We'd much rather apologise (to the beneficiaries) for leaving an unintended legacy rather than having our clients run out of money.
Once again, it's important to emphasise the importance of determining how best to generate a sustainable retirement income based on your individual circumstances - which may be very different from Brad's.
Want to find out more?
If you want to find out more about building a robust portfolio that gives you the best chance of retirement success, please get in touch.
About us
The team at Pyrford Financial Planning are highly qualified Independent Financial Advisers based in Weybridge, Surrey. We specialise in retirement planning and provide financial advice on pensions, investments, and inheritance tax.
Our office telephone number is 01932 645150.
Our office address is No 5, The Heights, Weybridge KT13 0NY.
Please note: This blog is for general information only and does not constitute advice. The information is aimed at retail clients only.