Despite rates falling over the past few years, around 400,000 Annuities are bought each and every year by retirees the length and breadth of the UK.
An Annuity is generally perceived to be the lowest risk option for people wanting to turn their pension into an income. But whilst the income it provides is guaranteed, there are risks with buying an Annuity. We thought we’d take a look at three of them and suggest ways to protect yourself and your retirement income.
Risk #1: Inflation
Inflation is the hidden enemy of Annuities.
When you buy an Annuity you have a choice between taking a level income or building in indexation, generally at a fixed rate or linked to RPI (Retail Prices Index).
Most people choose to buy a level Annuity, simply because the starting income is so much higher compared with an RPI linked Annuity.
A man buying an Annuity with £100,000 pension fund, would have a starting income of £5,517 if he bought a level Annuity with a 50% spouse’s pension, payable monthly income and a 10 year guarantee.
However, this would drop by a massive £2,400 per year, if annual rises linked to RPI were included.
The breakeven point, plus the lure of a significantly higher starting income, means most people opt for a level Annuity, but beware inflation!
Assuming 3% inflation over the next 20 years, the buying power of the income from the level Annuity will have reduced by a £2,500 per year, reducing the buying power of the Annuity by around 45%.
There are a number of ways of mitigating the risk of inflation:
- The most obvious is to include indexation in your Annuity, however, it is hugely expensive and may actually mean you get less back than from a level Annuity
- Consider an alternative option such as a With Profit’s Annuity or Income Drawdown, which could give the potential for a rising income if investment performance were good enough
- Spend other capital, perhaps from savings or investments, to help ‘top up’ your level Annuity income
- Reduce your annual expenditure each year
Risk #2: Making the wrong decision
Think for a moment about the big purchases you have made in your life; a house, a car, furniture, to name a few. If you make a poor decision you can sell up and move, part exchange the car or replace the sofa, in short you can change your mind if you make a mistake.
Now think about buying an Annuity, not only is it probably the second largest purchase you will ever make, in an industry filled with confusing jargon (overlap, guarantee periods, with or without proportion – you get the picture!), you can never change the Annuity you buy; even if you discover you’ve made a mistake.
So, you’ve no experience as you’ve probably never bought an Annuity before, you are committing thousands of pounds, and your income for the rest of your life is at stake, no pressure then!
Seriously though, it’s probably only in years to come that any mistakes made will come to light, when it’s far too late to do something about it.
Simple, take good quality independent financial advice.
Now, you might say we are biased, but there really is no reason not to take advice when you retire. Even Martin Lewis of MoneySavingExpert, who is hardly a friend of IFAs recommends, taking advice when you retire.
Why take advice?
- To be blunt an IFA has more experience in this field than you do, he or she will have advised many clients on their Annuity purchase
- An IFA will be able to approach providers not available for you to approach directly
- An IFA will be able to conform whether or not you qualify for an Enhanced Annuity, which could mean you get significantly more income each year
- An IFA will be able to haggle with the Annuity providers to get you a better rate
How much will this cost?
Generally less than if you go direct to an Annuity provider, who will still charge commission, or use a ‘non advised’ Annuity broker, who will charge you commission of up to 3%.
This really is one time in life, in fact possibly the only time, when taking advice will cost you no more than the other alternatives.
Risk #3: Your Annuity provider going bust
Everyone talks about an Annuity being a guaranteed income for life, which is true, as long as your Annuity provider can afford to pay you.
What happens if your Annuity provider goes bust? One of two things could happen.
Firstly a competitor may decide to buy the Annuity ‘book’ of the ailing company. Secondly, if this didn’t happen, the Financial Services Compensation Scheme (FSCS) would step in and pay 90% of the income you are due to receive, as well as honouring the original contract terms.
Researching, or indeed getting your IFA to research, the credit rating of your chosen Annuity provider is a start. Although this can only tell you so much, after all, many seemingly strong financial institutions have failed in the past.
If you have a large fund, you might also want to consider splitting your pot between two Annuity providers, to reduce the risk.
Other than these two tips, you should sleep a little more soundly at night, safe in the knowledge that should the worst happen the FSCS will be there to bail you out.
Do you need help choosing the right Annuity?
The small print (so important we put it in bold!)
Income Drawdown / Phased Retirement are only generally suitable for larger fund sizes and for individuals that are prepared to accept the risk of income decreasing and / or erosion of the fund value due to the investment risk involved.
Investment Linked Annuities involve an element or risk and the income from them can decrease depending on market conditions.