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Joe Moore - Financial Services > Blog > Should You buy an Annuity?
Annuity

Should You buy an Annuity?

The answer to this question will vary according to your personal circumstances. In broad strokes, you can take part as a tax free lump sum and then you will have the choice between purchasing an annuity and investing your money in an Approved Retirement Fund, or ARF for short.

What is an annuity?

An annuity is a financial contract. In return for an upfront lump sum payment, an insurance company will pay out an annual income that is guaranteed for the rest of the life of the owner of the annuity.

There are all sorts of different guarantees that can be purchased in an annuity contract, e.g., usually and annuity will pay out for the first 5 years irrespective of whether the client is still alive or not.

 A popular guarantee is that the annuity continues to pay out a percentage to the spouse for as long as they live if the owner dies first.

Each guarantee will lower the amount of income that the annuity pays out. It’s the price you pay for removing risk.

How are annuities priced and are they good value?

Actuaries will price annuity contracts. The key drivers of the price of the annuity are your age, the guarantees attached, and what the current interest rates are.

Currently interest rates are around zero, which makes annuity contracts very poor value. As a rule of thumb, a pure annuity at age 65 will provide 10% more income for every 1% of interest rate increase. So, if interest rates were around 2% today, instead of near zero, an annuity would purchase approximately 20% more income.

What are the benefits?

A guaranteed income for life. Knowing that your income is guaranteed for life is a huge comfort to some. They are immune to economic movements once purchased.

If you invested in an ARF instead, your fund is vulnerable to market movements and potentially running out of money before you die. With an annuity there are no such concerns.

The longer you live, the better value the annuity becomes. You could live past 100 and still be receiving the same income.

In some circumstances, you may take a larger tax free lump sum if you elect to purchase an annuity

What are the drawbacks?

When you die, so does the annuity. That is unless there are some other guarantees attached. It is not an inheritable asset, your children will not receive anything from the annuity after you pass on.

There’s no going back. Typically, once you have purchased your annuity, you are locked in. You can’t change your mind in a couple of years.

Mortality risk. If you die young, you wont have gotten much value from the annuity.

Credit default risk. This means, if the insurance company went bust, you could lose some or all of your annuity. Therefore, choosing whom to buy your annuity from is important. In general though, insurance companies are strongly regulated for this reason and they’re required to hold large amounts of capital reserves. so, credit default risk is low.

 

Inflation Risk. If inflation is high, it erodes the spending power of your annuity. In simpler terms, as things become more expensive over the course of time, your income will not be able to buy as much as it once did. You can however buy an index linked annuity where the income from the annuity will increase with inflation. Like any other guarantee though, this will come at a price and your initial income from the annuity will be reduced.

 

 

Overall verdict

In my mind, an annuity contract is one of the safest financial instruments available on the market but as of now, they are poor value because of low interest rates.

 If interest rates begin to climb, annuity rates will become more attractive. They suit people who want a fixed income for life and are risk averse. The healthier you are, the more likely an annuity will be of good value. They are not suitable if inheritance is a concern.

 

Get advice

Speak to your financial advisor about your retirement options and whether annuities are right for you. If you are leaning towards wanting an annuity in retirement, your investment strategy for the final 10 years of your working career should reflect this.

 

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