Weighing up the value of a guaranteed income for life

To call them the Cinderella retirement product might be stretching it, but annuities haven’t exactly been flavour of the month − or year, for that matter − for quite a while. They are seen by many as offering bad value in comparison to approved retirement funds (ARFs) with little if any time spent discussing their advantages.

This wasn’t always the case. In fact, as recently as 1999 the only option open to defined contribution scheme members and personal pension holders was to purchase an annuity with whatever was left over after they had taken their tax-free lump sum.

But annuity rates had been pretty good before that. In the mid-1980s rates north of 10 per cent were on offer. In other words, the insurance company issuing the annuity would pay you more than 10 per cent of your investment every year, guaranteed for life – €500,000 would have bought you a pension of more than €50,000 a year for life, guaranteed.

Sounds great? But life expectancy back then was 71 for the average Irish person. If you were that average person you’d only have six years to enjoy the pension. And a standard annuity dies with you, meaning that any money left over reverts to the insurance company.

Roll on 40 years and times have certainly been a changing. Life expectancy today is 82.9 years. That changes the equation, as does a dramatically different interest rate environment. For much of the 1980s and 1990s interest rates were in double digits; now we quake at the thought of the ECB base rate hitting 3 per cent.

Unsurprisingly, annuity rates have fallen accordingly, down as low as 3 per cent in the worst cases. Instead of €50,000, an individual with €500,000 to invest could expect €15,000. Things have improved, however, and rates of 6 per cent and above that are available in the market offer that individual a guaranteed €30,000 pension for life.

The alternative is an ARF which is a personal investment account offering tax-free growth but subject to normal market rises and falls.

There is still a place for annuities in retirement income planning, says Bernard Walsh, head of investments and pensions at Fairstone Ireland. “They hark back to the days of defined benefit pensions, when people had a sense that someone was looking after them. They like the feeling of their salary, or part of it, continuing. You can pick the payment date, and many people select the same date as their salary used to be paid.”

People should also consider the full range of options. “You need to look at the totality of pensions,” Walsh advises. “If two people in a relationship are retiring, one can choose an ARF and the other can choose an annuity. That gives them a mix of growth potential and certainty. Also, if someone retires with a number of pension pots from different employments, they can put one of them into an annuity and the others into an ARF.”

Flexibility is an important consideration, he adds. “One of the things a lot of people don’t necessarily realise is that they can decide to buy an annuity later with some or all of the money they have in their ARF. However, if you buy an annuity at retirement, it’s game over. The decision is made for all time.”

Shopping around is essential, he points out, noting that on one day in September rates of 6.2 per cent and 5.71 per cent were available from two different insurance companies, a difference of more than €2,500 a year for the €500,000 pension pot holder.

Munro O’Dwyer, who leads PwC Ireland’s retirement and pensions consulting business, says people need to understand the fundamental difference between the two products and the possibility of higher returns from an ARF comes with higher risk.

“You can take more risk, but your adviser should be very clear with you that that is what you’re doing,” O’Dwyer points out. “And risk works in two directions. It can bring more income, but it can bring less income and there’s no guarantee of greater income. You’re giving up guarantees and you’re taking on risk.”

He advises people to adopt a long-term mindset when deciding on an annuity or ARF. “Don’t just think about the 60-year-old you, because you’re not buying these products for the 60-year-old you. You’re buying it for the 70, the 80, the 85-year-old you. With an annuity, there’s no management to it. The big attraction of an annuity is you don’t have to deal with financial advisers any more. It just works and you don’t have to deal with people like me.”