Guest Spot: Exploding retirement income myths #3

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  • Author : Just
  • Date : 26 May 2021

For adviser use only.

‘Annuities are really bad value for money right now’

Now, like you I would wager, I’ve never read ‘Lady Windermere’s Fan’ by Oscar Wilde. I’m sure it’s a cracking read but even if you or I have no plans to open it, we do know some of the content, because one of its characters Lord Darlington, utters the following famous words to another, Cecil Graham, to describe a cynic, ‘A man who knows the price of everything and the value of nothing’.

That phrase has subsequently been used by many down the years to try and explain what Warren Buffet expressed perfectly which is, ‘Price is what you pay, value is what you get’.

So when I hear advisers and other industry commentators saying things like ‘annuities are really bad value for money right now’, presumably what they’re suggesting is the value (the guaranteed income for life) is not high enough in relation to the current price required by the insurance company to pay out that stream of income. We all know that technical things like yield curves and interest rates play a significant role in the pricing of guaranteed income products. Fixed income investments such as government bonds and high grade corporate debt are the assets held by providers to back their liabilities; so with interest rates at their current levels then this assertion surely must be right?

Well, to answer that we need to look at what other options are available to those in need of reliable and sustainable income now, and I think there are two key areas to consider. Firstly the most obvious one.

The very same fixed income assets held by annuity providers also make up a significant part of most portfolio asset allocations recommended by advisers to their retiring and retired clients. Normally held to help diversification and lower a portfolios volatility, and therefore its perceived risk, fairly modest increases in interest rates going forward could have a negative impact on capital values. So, unless a retiree is prepared to invest totally in equities and alternatives it’s difficult to see how a perceived negative towards the value of annuities doesn’t equally apply to a diversified portfolio in drawdown.

The other area to consider if we are really going to establish the value or otherwise of an annuity is what level of income could therefore be sustainable from the type of typically diversified portfolio we’ve described above. Flexi-access drawdown rules obviously now allow a retiree to withdraw whatever they want, but for every action there is a reaction, so taking too much too soon will increase the chances of outliving their assets and running out of income. This is something that can’t happen with an annuity and so we therefore need to compare on as fair a basis as we can.

To do this an adviser should plan for the funds to last to a point in time where the client is very unlikely to still be alive, with many using age 100, so let’s do that here. Secondly, to recognise the need for the income to last until age 100, a high level of probability of this outcome being achievable should be established by using stochastic modelling. Bearing in mind that there is a 100% probability of annuity income being paid throughout life, using something in the region of a 95% probability of the drawdown income being paid until age 100 feels fair and appropriate.

When we carried out 1000 stochastic simulations of a 60% mature equity, 40% investment grade bonds portfolio with an overall charge of 1.75%pa (which includes on-going advice fees) we established that a sustainable withdrawal rate for a 65 year old wanting income until age 100 was 2.73%, somewhat short of the often cited 4% number.

When we then look at the same fit and healthy 65 year old and see what level of income they would have received from Secure Lifetime Income available as part of the Novia SIPP, the equivalent income rate is 4.78%, which is a rather significant 75% improvement on what should be seen as a reasonable like for like comparison with the 60/40 portfolio.

So we started this article with Oscar Wilde’s character Cecil Graham describing what a cynic was. Many advisers may have become cynical as to the real value of holding an annuity as part of a client’s retirement portfolio. I’ll leave those who are interested to look up the dictionary definition of a cynic, while I finish by suggesting that annuities continue to offer good value, especially as part of a wider retirement income strategy.

If you’d like to find out more about combining guaranteed income with flexible income within the Novia SIPP please get in touch with your usual Novia contact.

Notes

The statements and opinions expressed in the Guest Spot are those of the author and do not necessarily reflect those of Novia Financial plc or any of its employees. The company does not take any responsibility for the views of the author. Any links, web pages and documentation within the Guest Spot are provided by pages maintained by independent third parties and Novia accepts no responsibility for the availability, content or use of the information contained within them.

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