How to make a pot of money last a lifetime- this is the crux of the retirement challenge.
While the retirement landscape has undergone significant changes, the fundamentals of the challenge have remained the same but the responsibility for addressing it has shifted from institutions to the individual.
Drawdown accounts are now the most popular way for consumers to use their defined contribution pension pots to provide an income in retirement. They offer flexibility (compared to a fixed annuity) but they also leave customers exposed to longevity and investment risks.
These accounts allow customers to potentially benefit from higher investment returns, resulting in a higher income or increased legacy; however, many retirees are unlikely to be comfortable investing wholly in high-risk assets such as equities.
Drawdown customers will instead be attracted to investing at least a portion of their funds in lower-risk but also lower-yielding asset types, such as bonds, to provide greater income sustainability. However, whilst bonds reduce investment risk they do not remove it entirely. In addition, they offer the customer no protection against longevity risk.
Annuities, by contrast, eliminate investment risk and longevity risk for customers by transferring these risks to the insurer. Therefore, a partial annuitisation approach may allow consumers to take on more investment risk with the remainder of their retirement pot which could lead to higher fund values over time.
Annuities can also potentially offer a higher effective return than bonds because insurers, as institutional investors, are able to access a wider range of assets than a typical consumer, including investing in less liquid, higher yielding, assets than bond funds. Also, by not typically offering significant benefits on death, annuities should provide a higher income (all else being equal) than a bond fund, as any money left over on death in a bond fund would be paid to dependents.
So, if customers are looking to invest a portion of their retirement fund in something low risk which will helps provide a sustainable income, should they consider annuities over bonds?
Recently we conducted a piece of analytical research to look at whether replacing an investment in bonds (held in a drawdown fund) with an annuity could result in a more effective retirement strategy.
We modelled thousands of consumer profiles and preferences across 1,000 economic scenarios. The results showed including annuities within the retirement “asset mix” could potentially have a meaningful positive impact on both the sustainability of that income and the fund value returned on death, or the“death benefit”.
Let’s consider a 65 year-old in good health with a pension pot of £100,000, we’ll call her Robin. Robin is targeting a £4,000 annual income, increasing with inflation. We assume an initial asset allocation of 5 per cent cash, 55 per cent equity and the remaining 40 per cent in either bonds or an annuity. We modelled the two strategies to see whether the “annuity-equity” strategy could offer better results than a pure drawdown“equity-bond” strategy.
We saw that if Robin lives for 25 years or longer, which she is statistically likely to do based on current life expectancy in the UK, the annuity-equity strategy provides a better chance of Robin being able to meet her target income for the duration of her retirement.
But the benefits of an annuity-equity strategy are not just limited to sustainability of retirement income. The annuity-equity strategy can also lead to higher death benefits in later years. For example, Robin, as a 65 year-old in good health, has a 50 per cent chance of surviving to 94; at this point the average death benefit under the annuity-equity strategy is approximately £55,000, whereas it is about £40,000 under the bond-equity strategy.
Overall, our analysis indicated that, for longer periods of retirement, combining an annuity with an equity drawdown could lead to a higher likelihood of achieving a person’s target income and a higher death benefit compared to drawing down from a mixed bond and equity investment fund.
Therefore, for those in good health, with a realistic expectation of enjoying a long retirement and who want their pension pot to provide an income throughout, then the annuity-equity strategy showed promising results.
During the run up to, and in the aftermath of, pensions freedoms, the reputation of annuities has undoubtedly suffered, perhaps unfairly. However, while customers now have more discretion over their retirement products, our analysis strongly highlights the importance of continuing to consider the product as part of a customer’s retirement strategy.
For more results and analysis the full report is available here.
Marie-Lise Tassoni and Fred Vosvenieks are consulting actuaries at Milliman, a global actuarial firm.