Buying an annuity is a gamble which can lose all your money – the income is ‘safe’, but your capital isn’t!
by Dr. Ros Altmann
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Regulators not ensuring consumers understand the risks of annuities
Defined contribution pension trustees must do more to look after retirees – explain benefits of ‘do nothing’ option for small pots
Annuity purchase is a big gamble:
Buying a standard annuity in your 60s, which is a relatively young age, is gambling on you staying fit and healthy and living to a ripe old age. It is a gamble that inflation will not be a problem for the rest of your life, that interest rates will not go up again and that your health will not deteriorate much, if at all. If you are happy to bet all your money that you will not become ill, that inflation will not be a problem, that interest rates will not go back up again, that your circumstances will not change, and that you will not die sooner than expected, then a standard annuity is fine for you. But, you need to understand that this is what you are doing, because once you have given your money to the insurance company and bought the annuity, if your circumstances do change, your money is gone and you will not have a second chance.
Buyers should be given proper risk warnings:
Far from being a low risk purchase, buying an annuity could be the biggest gamble you ever take in your life. An annuity purchase is a long-term investment decision, which risks losing much or all your money, yet people are given no risk warnings about the dangers of buying. If you die soon after you buy a standard, single-life annuity, your pension fund will go to the insurance company, not to your loved ones. If you buy a financial product that can lose more than three quarters of your money, it would usually be considered ‘high risk’ – and those selling it to you would surely have to give you a proper risk warning.
Most people think annuities are low risk products – they can be very risky:
Buying a standard annuity, even with a five year guarantee, risks losing nearly three quarters of your money and without any guarantee could mean losing all your money. Yet people often say that buying an annuity at retirement is the low risk or even ‘no risk’ option. This is not true. At current rates, annuities offer little protection against many of the risks people will face in their retirement. That leaves most people exposed to significant risks when they buy annuities, and their pension savings, which were supposed to protect them in retirement, may end up worth little or nothing to them.
A standard annuity promises a ‘safe’ regular income, but your capital is at risk:
Buying an annuity is considered the ‘safe’ thing to do when reaching retirement. This is misguided. The ‘safety’ only refers to the fact that the amount of income will be set for the rest of your life. But the capital itself is at risk. Most people will receive a very poor return on their money – and many will not get their money returned to them at all. Anyone who does not live to age 82 will not even have all their pension fund paid back to them before they die – and will have received no interest on their fund and no inflation protection. The insurance company will have had their money for many years and earned returns on it, while the pensioner who buys a standard annuity at age 65 will not see any return on his or her money before age 82.
A lifetime annuity at age 65 is not really a ‘safe’ option, so what are the risks?:
A lifetime annuity, bought at a relatively young age of 60 or 65, exposes pensioners to significant risks which they cannot protect themselves from during retirement. Their pension income will not provide cover for any of the following risks:
Annuities leave you open to risks
|Dying relatively young||If you die soon after buying your annuity you lose most of your pension savings. If you have not yet annuitised and die before age 75, your fund passes to your family tax-free|
|Inflation||As inflation rises, your level annuity becomes worth less and less each year|
|Strong investment returns||If investment markets are strong, your pension fund cannot benefit|
|Rising interest rates||If interest rates rise, you cannot benefit from better annuity rates in future|
|A change in personal circumstances – such as spouse getting ill or dying||Locking into an annuity at age 65 means any change in your circumstances will not be reflected in a better pension income in future|
|Becoming ill – or more seriously ill||If you buy an annuity in good health and then become ill, or if you have an enhanced rate but become more ill, you cannot benefit|
|Funding long-term care needs||Giving all your pension fund to an insurer will leave no money to fund long-term care if you or your partner needs it later|
|Living much longer than expected||This is the major risk that an annuity DOES protect you against, but you need to live to about 90 before they are good value. Meanwhile, the annuity leaves you open to all the other risks listed above|
Are pension trustees doing enough to protect members?:
Many defined contribution pension trustees take great care to ensure their members’ pension funds are invested well, have good investment options and reasonable charges, but when it comes to the point of retirement, are the members being properly looked after? Ideally, they need advice from an independent whole of market financial adviser to decide what’s best to do with their pension savings. The annuity purchase decision is complex and it is easy to buy the wrong product without realising the consequences until it’s too late. At the moment, trustees will often send members to an annuity broking service. This effectively recommends they should buy an annuity with their fund and those with small pots are led to believe annuitising is their only option. In fact, they have the option of simply leaving their money alone to grow (hopefully) in future.
Trustees can help members with ‘small’ pots to consider the ‘do nothing’ option:
Those with what the pensions industry calls relatively ‘small’ amounts of pension savings are told that they cannot really do anything else with their money. These so-called small pension funds can be anything from a few thousand pounds up to £50,000 or even £100,000. Locking into an annuity is often said to be their only option. Anything else is called either too expensive or high risk. Nowadays, however, with annuity rates having fallen so much, buying an annuity is certainly not ‘low risk’ because you can lose all your money. This is particularly relevant to trustees of pension schemes where the defined contribution (DC) pension pot comes from AVCs, or is a small amount of DC accrual from a closed scheme where the member has a reasonable final salary or defined benefit pension in place. Those with other pensions may well be best advised not to buy an annuity yet. But unless their trustees inform them of this option and the risks of annuitising immediately, they will not know. The annuity broker will not tell them they don’t have to annuitise! People need advice to understand what their options really are. Just being signposted to an annuity buying service, so they can ‘shop around’ for a better rate, is not enough.
A £10,000 pension fund pays around £10 a week in standard annuity from age 65:
If you have other sources of pension income, or decide to keep doing some part-time work, you could be better off waiting before buying an annuity. The ‘do nothing’ option will give time for your fund to grow further, time to see if your circumstances change, time to see if annuity rates go back up again and time to assess whether you might need a different type of annuity later on. This ‘do nothing’ option leaves your money available to you and your family. Indeed, if you die before age 75 and have not taken any money out of your fund, it will pass on tax free to your loved ones.
FCA and tPR need to ensure better consumer protection and risk warnings:
We need to make annuities work better for those reaching retirement. As DC pensions are the future, the current market failures need to be urgently addressed. I do hope the FCA and the Pensions Regulator will wake up to the need for better consumer protection in this complex, irreversible process that can leave many pensioners much poorer than they should be for the rest of their or their partners’ lives.