A Bird in the Hand

Two recent pension surveys caught my eye last week.  The first suggested, somewhat unsurprisingly, that retirees prefer a guaranteed income to an equivalent sum of savings.

 The report was based on lifestyle survey data and the analysis contained a lot of squiggly charts and tables of data.  The upshot though is that increasing guaranteed income appears to encourage social participation (and other activities associated with the feeling of wellbeing) to a degree not matched by merely increasing wealth.

The survey was conducted specifically to investigate issues relating to the pension freedoms introduced in April of this year.  These gave many retirees an alternative to simply purchasing a guaranteed income in the form of an annuity.  Effectively the freedoms present investors with a choice between a fixed income for life (an annuity) and investing, at their own risk, to provide an uncertain level of income.

It’s not hard to see where the stress comes from.  Producing an acceptable income from savings has always been a challenge, one that eludes many “professionals”.  The current low rate environment exacerbates this problem.  Add in a generalised lack of financial self-confidence, not to mention the intimidating “mystique” surrounding investment, and it’s easy to see why most pension savers are happy to let others take responsibility for their retirement income.

However, even leaving aside the emotional and educational aspects, uncertainty creates real risk and people are prepared to pay significant sums to avoid it.  Indeed the entire premise of insurance industry is that people will pay more in premiums than they’ll ever claim from their insurance policies.

Another way of looking at this is from the perspective of an annuity provider.  Previous blog entries on this site have illustrated just how expensive it is to buy an indexed-linked pension compared with a level annuity that pays a fixed income for life.  Adding indexation sees the provider assume the risk of protecting their clients from future inflation.  Even ignoring inflation, providers still run the unquantifiable risk of longevity.  It is this, combined with current low interest rates, that make annuities appear such poor value.

Another survey indicated that typically only 6% of retirement income comes from savings.  48% comes from benefits or the state pension, whilst private pensions chip in 42% on average.

These two surveys would appear to support each other inasmuch as savers’ lack of comfort with cash, as opposed to a secured income, suggests that they “value” savings less.  Of course there may be practical issues that limit an individual’s ability to save.  However, it is a shame that the flexibility of savings is underappreciated.

The slight irony is that the various regulatory developments that have occurred since the vast majority of these private pensions were accumulated have indeed made private pensions a more rational choice as a means of long-term saving.  With the 55% Death Tax removed, pension pots can be passed on intact and sometimes entirely tax free.  That is a significant advantage  compared with seeing your entire pension pot disappear upon the death of you and your partner, simply because you wanted to remove all income uncertainty from your life by purchasing an annuity.

The inescapable, and somewhat unfortunate, result of all this is that pensions have become even more complicated and daunting than ever.  Annuities remain an option, but the opportunity cost of buying one has increased substantially now that pensions can be spent or passed on at the pensioner’s absolute discretion.  In many ways a pension is better than a trust.  The pensioner remains in control of the funds for their lifetime, but can pass them on to their direct descendants tax free.

Ironically this inheritance tax advantage may cause investors to leave their pensions intact and instead rely on non-pension savings for their retirement income.  Which neatly brings us full circle to people’s aversion to saving!

Take care out there


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Is it better to go for an index-linked pension or a steadily rising annuity

As I discussed last month, people often underestimate how much it costs to protect your pension from the ravages of inflation.  We saw, for example, that a £100,000 pension pot might typically buy you a level annuity of £5,448 a year.  This would remain constant for the rest of your life, which could easily be another 30 years.  If, however, you wanted your income to increase by 5% a year, your starting annual income would almost half to £2,815.  To put that into perspective, you would have to live until you were 90 before you broke even on your decision to opt for a 5% annual escalation.  That is six and a half years longer than the current male life expectancy.

However, a 5% annual increase is actually considerably above the current inflation rate.  Indeed over the past year the Retail Price Index has increased by just 0.9%.  Even if you go all the way back to 1981, the average only climbs to 3.85%.  In view of this, if you merely wanted your pension to increase by the rate of inflation, rather than a fixed 5%, you might expect that your starting level would be higher.  And you would be correct!  Instead of starting at £2,815 and increasing by 5% a year, you would start at £3,294 and rise in line with inflation.

Of course we’ve got no idea what inflation will be over the next few months, let alone the next 30 years.  However, if you assume that inflation going forward will be the mirror image of what it has been over the past 25 years, i.e. starting low and then building to peaks to reflect the spike in prices in the early 1990s, you come up with some interesting figures.  You would, for example, have to live until 97 before you would have been paid as much by an RPI-linked annuity as by the level annual payment.  A clearer indication of just how expensive it is to protect yourself against future inflation is that you would only have to live until 78 (having retired at 65) to be better off opting for an annual 5% increase rather than a rise based on inflation.

This illustrates two things.  Firstly it is very expensive to provide an escalating pension, especially one linked to future inflation risks.  This is because you are asking the annuity provider to effectively “insure” you against unknown future price increases.

The even more significant risk that all annuities insure you against is longevity risk.  That is the risk that you live longer than you or your annuity company have budgeted for.  An annuity will, generally, keep paying out until you die, whether that is at 66 or 106.  It is true that you can pay extra to have the income guaranteed for a minimum period of 10-years.  This means that your beneficiaries don’t lose the value of the entire £100,000 if you drop dead far sooner than you might have hoped.  However, this generally doesn’t cost that much (but I will cover this in another update).  By far the greater cost to your annuity provider is if you live on to a ripe old age.

The point is that the “insurance” element shouldn’t be underestimated, both in terms of its cost, but also in terms of its value.  One way of appreciating how much you are being charged is to consider that the average male life expectancy is 83.5 years.  If you were simply to keep your £100,000 pension pot and take an income of £5,448 (equivalent to the level annuity and assuming no investment growth whatsoever), your pot would last until you were a little over 83  years and four months old.  Basically the price you are paying the insurance company for agreeing to sustain your pension until you die is equivalent to every last penny you may have earned on your £100,000 for almost 20 years.

This is not to say nobody should buy an annuity, or that they shouldn’t have it inflation-linked.  What it is saying though is that these things cost money and you can only really appreciate how much if you delve a little deeper.

Take care out there


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What price an index-linked pension?

People are often shocked at just how much an index-linked annuity costs relative to one that pays a level income for life.  Imagine if you will, you have a £100,000 pension pot that you are seeking to convert into pension income.

According to the Daily Telegraph, Aviva will exchange your £100,000 pot for a lifetime annual income of £5,448.  However, if you were to require a 5% increase each year, your starting income would be just £2,815, almost 50% less.

That begs the question, how long would you have to live before you “broke even” on your decision to opt for the escalating income?

A simple spreadsheet shows that you would have to live until you were 90 to have been paid as much from an escalating pension as you would have received from the level annuity. By that point though the escalating pension pays you an annual pension of £9,532, whilst the level annuity would, of course, remain at £5,448.  Thereafter the escalated pension moves ahead quite quickly. Indeed by the time you receive your telegram from the Queen (or King) on your 100th birthday, you would have received a total of £73,000 more from an escalating annuity.

For context the average male retirement age is 64.6 years and life expectancy at that point is 83.5 years.

Of course the real world isn’t quite this simple. Inflation, for example, invariably means that a pound received early on is worth more than one received twenty years later. Also most annuities make some sort of provision for surviving spouses. Over the next couple of updates I will delve into a few of these complexities. Even if you don’t intend to buy an annuity, inflation is still something that you will have to take account of to ensure that your savings last for your entire retirement.

Take care out there



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