Are investment-linked annuities right for you?
What are investment-linked annuities and are they the essential retirement planning tool?
Annuity rates have fallen continuously over the last 20 years to reach their lowest level ever.
This fall has been driven by the yield on fixed interest investments, such as gilts and corporate bonds, falling to their lowest level since records began in 1703. The increase in longevity has also impacted on rates.
Conventional annuities have been the default product for investors who are looking for a guaranteed income for life. The peace of mind which conventional annuities offer remains an integral part of their appeal.
However, while these products are often billed as ‘no risk’ products as they are not impacted by ongoing stock market volatility, there still remains a significant risk of inflation eroding income in real terms.
Inflation, as measured by the Retail Price Index (RPI) currently stands at 3.1% which means many investors are suffering a ‘pay cut’ in real terms over time, especially since underlying interest rates for annuities tend to vary between 2%-3% per cent.
Falling gilt yields have been partly responsible for the evolution of a middle market. For many years, those who were about to retire were presented with the polar opposite options of conventional annuities, which are inflexible but offer investors the peace of mind of a fixed income, or drawdown, which is extremely flexible but far higher risk as it is dependent on GAD rates, (which are set by the Government Actuary Department and set the maximum amount pensioners in drawdown can take from their fund each year as income), and stock market movements.
Historically, those who want slightly more flexibility than that which conventional annuities offer, but still want the level of security which annuities provide, had very few options available to them. Insurance providers soon realised this and responded accordingly by developing products which offer a halfway house between conventional annuities and drawdown.
Investment-linked annuities are not as adversely affected by yields as conventional annuities, and income levels have held up considerably better than conventional rates. The advantage of taking more income up-front, while having the potential to grow that income, is becoming attractive to many retirees who plan to lead an active life at the start of their retirement.
In addition, these arrangements can be used as exit strategies from drawdown. With maximum income from drawdown recently reaching historically low levels, many are turning to these arrangements to boost their incomes.
Drawdown funds can be annuitised in stages; for example, someone phasing out of drawdown over a five year period can gradually de-risk over a period of time, perhaps to investment-linked annuities and ultimately to conventional annuities.
However, when deciding whether to invest in investment-linked annuities, it is important to understand all of the risks associated with them. Ensuring that you have sufficient income from other sources if you are going to opt to take the highest level of initial income is imperative.
In short, if the fund falls in value, it is important to ensure that you will not be short of income. Understanding your capacity for loss is another key consideration. If you can’t afford to lose the fund value, don’t take the risk.
The fact that people’s working patterns in the run-up to retirement are so varied, and that longevity is continuously increasing, means that investment-linked annuities will become even more popular over the next couple of years. Gone are the days of retiring from a job for life, and reaching for your slippers and pipe. Many of today’s retirees are climbing Machu Picchu and working part-time which explains why the option of a flexible annuity – where you can vary the level of income which you take out – makes perfect sense.
However, although sales of these halfway house products increased dramatically in 2012, conventional annuities remain the most popular retirement product.
With retirement patterns having shifted to become far more flexible, and annuity rates not expected to bounce back anytime soon, it is likely more retirees will look to more flexible, mid market products.
Shopping around – not only for the best rates, but also for the most suitable products – will hopefully characterise 2013, as retirees choose products which best suit their financial needs. However, many of these products are complicated and so it is always important to contact a financial adviser or retirement specialist before making such a significant investment decision.
- By: Colin Simmons
- 15 Jan 2013