It’s been a while since my last post. Life sometimes gets in the way of writing plus I wanted to conclude the purchase of an annuity so I could write about the reasons behind the decision. All things related to pensions never seem to be quick and simple and this transaction was no exception.
The purchase of another annuity wasn’t in my grand plan but the jump in annuity rates caused by the increase in gilt yields changed the economics and as John Maynard Keynes is quoted as saying:-
“When the facts change, I change my mind – what do you do, sir?”
Anyone who has read my post describing my retirement income strategy will know that my income is derived from four sources:
- UK State Pension
- Level Lifetime Annuities
- Investment Trust Dividends
I had used some of my SIPP to purchase a small annuity plus I had another very small one from some years back. Partial annuitisation can be very useful in boosting the early-years income and providing a little extra guaranteed income not subject to the vagaries of the stock market.
As I have spent many years overseas during which I couldn`t contribute to a UK pension the SIPP only represented about 25% of my retirement savings. I had intended to keep the remaining funds in my SIPP as a kind of emergency fund in case I ran out of money a lot longer down the retirement road and of course, there is protection for my beneficiaries from inheritance tax. However, the recent jump in annuity rates made the purchase of an annuity a very attractive proposition.
Whereas a couple of years ago a level single annuity for a 65-year-old was paying about 5.3% and an inflation-linked annuity less than 3.5%, in July of this year at age 68 I was being quoted 8.3% for a level annuity and over 5% for an inflation-linked annuity. These rates are for a single life (my wife is financially secure so there was no need to purchase a joint life annuity). When one considers that an optimistic Safe Withdrawal Rate (SWR) from a drawdown portfolio is 4%, and a conservative rate is less than 3.5% then an annuity is a very attractive option.
Level or Inflation Linked Annuity?
There are two factors to evaluate; (i) annual income – how long it takes before the income from an inflation linked annuity exceeds the income from a level annuity (ii) How long does it take before the total real income received from an indexed annuity exceeds that from a fixed annuity.
The UK’s historical inflation rate over the last 50 years is 4.1%. As shown below if future inflation is at this level then in terms of annual income you`ll be better off with the inflation-linked annuity after 14 years and in 11 years if inflation averages 5%:-
- 3% Inflation 18 Years
- 4% Inflation 14 Years
- 5% Inflation 11 Year
Statistically, even if inflation is at a low of 3% then I should live long enough to see an inflation-linked annuity to eventually pay out more every year than a level annuity and if inflation averages as in the past then after 14 years my annual income will be higher with an indexed-linked annuity.
However, the situation isn`t quite as clear as it would at first seem as shown in the graph below which looks at the total “real” income received over the years. This is income adjusted for inflation as obviously £1000 of income today will have far more purchasing power than £1000 in 20 years’ time.
As the graph shows even if annual inflation averages 5% it takes 24 years before the total real income received from the inflation-linked annuity matches the total real income received from a level annuity. And over the important “high spending” first ten years of retirement the level annuity produces 40% more inflation-adjusted income than the indexed linked annuity.
Perhaps if I were to be 100% dependent upon annuity income then I would consider the inflation-linked annuity because I remember well the super-high inflation of the 1970s and as we have seen recently anything can happen and often does with global economies. However, annuity income will represent less than 30% of my total retirement income with the remaining 70% offering some inflation protection so the opportunity to boost my income during the early part of retirement and to increase the percentage of income not dependent upon stock market performance is an attractive proposition and one that I decided was worth taking.
Retirement Income Distribution
The pie chart below shows the new distribution of pre-tax retirement income. Total income is around £52k/year with income, dividend, and capital gains tax estimated at around £3K in 2023/4. Thereafter who knows but I guess it won`t be less! Fixed single-life annuities represent 30% of my income. The remaining 70% is split between state pension, total return drawdown, and dividend income from an investment trust portfolio. Nearly 50% of the income is from sources independent from market performance.
My objective is to use the annuities to provide a boost to the first decade of income with the other income sources providing some protection against inflation.
In Morningstar`s report on The State of Retirement Income: 2022 one of the drawdown strategies examined is to limit annual increases in the drawdown to 1% less than the rate of inflation. This is based on the research by David Blanchett that shows most retirees decrease their real spending by 0.96% per annum from age 60 to 90. (The exception to this is when health related expenses such as care home fees hit hard).
The graph below shows my projected real (adjusted for inflation) annual income for 3%, 4%, and 5% annual rates of inflation. I have assumed that the state pension and dividend income will keep up with inflation but that the drawdown income will be 1% less than inflation as I am front weighting my drawdown income by using a 5%+ withdrawal rate. At 4% inflation, the real income over 25 years declines from around £51K to £40k. This is an annualised rate of decline of 1.1%/year. It must be remembered that the use of annuities boosts the initial income by around £6k/year compared to planning for annual inflation linked increases.
Of course, the nominal (non-adjusted for inflation) annual income increases significantly. At 4% inflation at the end of 25 years, it has increased from £51k to £83k
For the first time in more than a decade annuity rates are attractive and can be a real and superior alternative to pension drawdown. For a single person, an inflation-linked annuity paying 5% or more beats the 3.5% or so Safe Withdrawal Rate (SWR) of drawdown, and it`s completely safe. No worries about stock market performance and whether one will outlive the portfolio. Joint life annuities offer rates that are comparable to drawdown SWRs but again without the worries of market performance and longevity.
Many retirees hate the idea of signing away their savings, maybe dying early and “losing” their investment and not leaving behind an inheritance. An important role of an annuity is to provide insurance against living too long. A retiree with limited funds may have to accept that he cannot have the maximum possible safe income that only an annuity can provide combined with the probability of being able to provide an inheritance .
A retiree with sufficient assets can opt for partial annuitisation so there is the possibility of having funds available for the heirs whilst being able to have a higher safe income during retirement. In the case of partial annuitisation there is also the prospect that the higher income provided by an annuity can reduce the drain on other assets and partly compensate for the reduction in inheritance funds.
Some Caveats About The Process of Annuity Purchase
Nothing is straightforward when dealing with pensions. In my case I purchased a Legal & General annuity via Hargreaves Lansdown and my SIPP was with AJ Bell.
I had previously purchased via HL and had already two small annuities with L&G so I wasn`t anticipating any big administration problems. Strangely the H&L quote was higher than that directly from L&G. I can only assume that L&G wants to motivate their sales channels by avoiding competition.
Having learned from my previous annuity purchases I wanted to smooth the path so I liquidated by SIPP to have only cash, and submitted the forms that AJBell required together with the annuity application to HL.
A big risk is that the annuity quote only has a 30-day validity plus another 30 days of tolerance given by L&G. So in effect you have 60 days from the date of the quotation for the funds to arrive in L&G’s bank account. If it takes longer than that L&G will issue a new quotation. This in fact happened to be with my last purchase and resulted in a reduction of around 1.5% in the annuity payout. However, that was in a time of stable gilt yields. The last few months have seen pretty unstable yields so there was the potential for a large variation in the annuity value which I wanted to avoid.
I asked the question to L&G what would happen if they received funds outside of the time limit and I didn`t accept the revised quote. I was told that some SIPP providers might accept the funds back – potentially a pretty problematic situation. L&G could not extend the quote validity. I wanted to avoid the possibility of my pension funds being left in limbo so I was constantly on the `phone with AJBell and L&G which was a good thing because there were some hiccups with AJBell but finally the funds were transferred to L&G on the penultimate day of quote validity. L&G then took a further 3 weeks to finalise the purchase and payment was backdated to the day they received funds. It was 3 months in total from the quotation to receiving the first payment.
I don`t know if other providers offer longer quote validity but as we are in an era of changing interest rates, and probably reducing ones which will reduce annuity rates and it only takes a couple of admin hiccups for delays to occur and quotes to expire. So it’s vitally important to have your ducks in a row and to keep on top of all the institutions that form the chain.