Annuities: the trickiest pension decision of all?

As Prudential is fined £24m for its former practice of selling annuities to customers without encouraging them to shop around, there are signs that these retirement products are becoming better value – for those who choose wisely. Article by Nick Green.

The financial regulator has penalised Prudential for sales practices that occurred pre-2013, for not offering consumers the choice of retirement products they were entitled to. Savers who belonged to Prudential pension plans were targeted by the firm’s annuity sales teams, who were incentivised with bonuses and other perks to sell Prudential annuities directly to the customers.

By law, pension providers must explain to customers that they may get a better annuity rate by looking elsewhere. The FCA ruled that Prudential took insufficient steps to ensure that this happened in all cases, and may have encouraged mis-selling. Prudential has since ceased its ‘non-advised annuity business’ and will pay compensation to those affected, but the ruling is a timely reminder of the importance of shopping around a number of different providers when selecting such products.

The pros and cons of annuities

An annuity is an insurance product that will pay you a guaranteed income for the rest of your life. It’s typically purchased using part or all of your pension pot, which you will have saved up throughout your working life.

The main advantage of an annuity is that can never run out, no matter how long you live. The main drawbacks are that it’s possible to get back less than you spent, and once purchased an annuity can’t be refunded. Also, unlike a pension pot, it can’t be passed on to beneficiaries (although if you have a joint annuity it will continue paying out a reduced amount to your spouse). This makes buying an annuity one of the biggest decisions of a person’s lifetime, requiring a lot of thought and preferably independent advice.

Annuities may be growing more competitive

Before 2015 (when pension freedom was introduced) there were few realistic alternatives for accessing pension savings, other than buying an annuity. Most people were effectively forced to buy one – which had a predictable effect on the value for money being offered.

Nor was it just the lack of competition that drove annuity rates down. It has since emerged that pension companies were over-estimating the life expectancy of their customers. Life expectancy at 65 is now more than a year lower than it was in 2015 – meaning that these pension companies were essentially over-charging for their annuities (since they won’t have to pay out as much).

The good news is that this picture is beginning to change. In 2016 the best annuity rate available was 4.5 per cent – meaning that a pot of £100,000 would buy you a guaranteed income of around £4,500. But by March 2019 it was possible to find rates of at least 5.5 per cent – providing over a thousand pounds a year more income, for the same outlay. The reasons for these rising annuity rates are twofold: the fact that providers now have to work harder to attract customers, and the new, lower estimates of life expectancy. Further increases in annuity rates are likely as both of these pressures take effect.

Things to consider if choosing an annuity

The Prudential case highlights a fact that people often overlook: namely, that not all annuities are the same. Pension savers may mull over the basic question ‘Should I buy an annuity?’ without considering the many competing products available.

Different providers will offer a range of different annuity rates, and even small differences can be magnified over the 20+ years that an annuity may run. As price comparison sites demonstrate, over 20 years there can be between £7,000 and £9,000 worth of difference between the best annuity rates and the worse (when comparing annuities bought for £100,000). Competing providers may also vary in the special products they offer, and the relative cost of these. Such products may include:

• Joint-life annuities (which will continue paying out to your spouse if you die first)
• Increasing annuities (where the payout rises with inflation)
• Enhanced annuities (which pay a higher income if you have certain health conditions)
• Guarantee periods (you can ensure that your annuity will pay out for a minimum number of years, even if you die sooner)
• Value protection (where your spouse or other beneficiary will be refunded the initial cost of your annuity, minus any money already paid)

People who take the first annuity offered by their existing pension provider are therefore potentially missing out by thousands of pounds. Shopping around is therefore essential, preferably with the help of independent financial advice.

Using other pension options alongside an annuity

Another factor to bear in mind is that retirement is a long time, and your income needs may vary considerably over those two decades or more. As a rule of thumb, you are likely to want more flexibility in the early years of retirement, and more security in the later years.

For some people, this may be a good reason to delay buying an annuity until later in life. This offers a couple of advantages: firstly, you will be looking at a shorter lifespan to cover, so could expect a higher guaranteed income. Secondly, annuity rates may have risen further by then (though this is by no means certain).

One possibility is to use drawdown in those early years, then use your remaining pot (assuming you have conserved it carefully) to buy an annuity to last the rest of your life. Another popular option is to buy a smaller annuity at 65 and retain enough of your pension pot to supplement your income with drawdown, as required.

The best options will vary from person to person, depending on one’s needs, preferred lifestyle and other circumstances. This is why it’s so important to plan your retirement income with the help of a financial adviser.