There is banter behind my back! It relates to the annuity puzzle. You want to know what that is? Please read on!
Most “experts” reckon annuities are better value for their money than they were. But I don’t get the impression many of us will buy one! The puzzle remains!
Annuity puzzle? Well hear it is…
Let Richard Thaler ask that again….
This “annuity puzzle is brought up by “dearie me”,
But there’s nothing irrational about Derek Scott’s hatred.
The annuity puzzle indeed describes an apparent contradiction in behavioural economics.
Life-cycle models predict that people should widely buy life annuities to guarantee lifetime income and protect against outliving their savings.
Yet, in practice, few retirees voluntarily purchase individual immediate annuities, preferring to live off other savings or ad hoc lump-sum withdrawals.
Annuities are said to insure against longevity risk, meaning you cannot outlive your money. Unless you buy a fixed term annuity.
There is even arguably a “mortality credit” as pooled funds at least in theory redistribute money from those who die early to those who live longer, offering higher payouts than standard investing might.
But many people tend to underestimate their longevity and/or their luck, so a fear they will die earlier (being unlucky) perhaps creates reluctance to reward others (the lucky ones) who live longer?
Modelling suggests people should convert all or most retirement wealth into annuities.
But Warren Buffett in his 2008 letter to shareholders wrote:
“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of geeks bearing formulas.”
Reasons why people may avoid annuities in practice? Are they being irrational?
Bequest motives. Retirees want to leave money or an inheritance to their children or heirs or favoured charities.
Or liquidity preference. Locking money away in annuities prevents access to lump sums for unplanned events, unexpected emergencies or health care costs.
Or loss aversion and framing. Many retirees may view annuities as a risky financial bet rather than steady monthly spending insurance.
While they’re unlikely to describe it as “counterparty risk” many seem
to fear that the issuing insurance company or provider could face financial trouble down the line.
Our media’s tendency to report and emphasise bad news (the exceptions, things that happen to individuals) rather than emphasise safeguards and other support mechanisms (which operate in favour of the vast majority as a rule) is responsible for at least some of the negative framing.
The aphorism “in life they tax income …” captures a useful instinct that the optimal tax planning characterisations change over your lifetime, but it mistakes tax character for economic ownership.
During life, lower-taxed capital treatment can genuinely be very valuable.
At death, the question is not so much whether your wealth was called “income” or “capital”, it’s whether your estate still owns it, what exemptions and reliefs may apply, and how CGT rebasing, IHT, pensions, spouse exemptions, gifting, and past spending interact.
While simply reclassifying retirement capital as income without disposing of it accomplishes little or nothing for IHT purposes, and it may trigger unnecessary income tax sooner or later along the way.
Let’s not leave it there… here’s Derek again! Though he has supported annuities so far, he turns on Standard Life for a misleading number. this is the #13 below – a quote from Standard Life.
“The payback period for a £100,000 annuity purchase with a rate of around 5% in 2020 would have taken around 20 years to repay. However, with today’s rates closer to 7.75%, that falls to around 13 years, depending on individual circumstances”.
A Bean Counter’s breakdown of that misleading Standard Life Number.
The Break-Even Payback Hurdle: You must live at least 13 years just to recover your original capital (£1/7.75%= 12.9). Up to this point, your gross rate is negative because you have not recovered your principal outlay.
The “Mortality Credit” Shift:
If you die early, the insurance company keeps the remaining capital, resulting in a negative return for your outlay.
If you outlive average life expectancies (20+ years from age 65), you could benefit from “mortality credits” (subsidised by those who died early), driving your true rate earned closer to maybe 5%.
Underlying Asset Matching:
I think insurance companies back lifetime annuities primarily using long-term government bonds and gilts.
As long as those institutional yields sit lower than the quoted payout, as they do currently, the gross return of a 7.75% annuity can never mathematically match 7.75%, unless you survive well into your late 90s.
In the UK of course, payments from a lifetime annuity bought with a pension pot are treated as earned income. Your provider or scheme administrator will presumably deduct income tax using the PAYE system before sending you the money.
And because the full State Pension (£12,548 a year for 2026/27) already consumes almost the entire £12,570 tax-free Personal Allowance, virtually any extra annuity income you receive on top will push your total earned income past the threshold and be fully taxable at your basic marginal rate of 20%.
No mention of guaranteed periods or value protection? They have a role, too. I have arranged many annuities over my 36 year’s as an IFA, to the best of my knowledge, only two individuals have died in the first 5 years of doing so. We have one client who spent £775,000 from a SSAS at age 60 to purchase an annuity with AEGON Scottish Equitable in 1993. IRC paid £8,500 per month. She is still bombing around Bristol in her electric Mini age 96 and has received payments of around £3.7m! An exceptional example of “longevity insurance”.
There are a couple of other things to say here. Firstly, what about the potential “IHT Solve” post 6 April 2027 that a combination of annuities and, perhaps, a term life or whole life insurance policy (assuming qualification) written into trust can bring? Spend, say, £100,000 on a pension-funded annuity and be paid, say, £7,750 a year from age 67. For a 20% taxpayer, that’s about £516 a month, net (for a level, fixed, annuity). Today, Zurich Assurance quotes a premium of £92.98 per month (subject to underwriting & non-smoker rates) for £100,000 level life cover for 15 years. So, the £100,000 life cover is outside of the estate (because it is in a simple life assurance trust) and we cater for any early failure of the “longevity insurance” offered by annuities.
Secondly, I have been involved with some basic market research with a major life office that is considering returning to the “Purchased Life Annuity” market, to add competition to the current offerings from Avia & Canada Life. We know that the tax treatment of annuities bought with one’s own money is different (tax-free capital element, taxable interest element) and that the rates are a touch lower than pension-funded annuities (because of “anti-selection”), but again, the capital has immediately gone from one’s estate in return for a tax attractive income (in most cases) and a life insurance policy could be optionally used here too.
Last year, I helped with a lady who was anxious about IHT (I know, I know) and short of income. We agreed to spend just enough – about £40,000 – on a PLA to bring her estate valuation below £500,000 using conservative assumptions and the extra income means that, as she said, she can afford a bottle of premium milk rather than the essentials range from her local Waitrose!
Please keep Billy Burrows company at our Pension PlayPen meetings at 10.30 am on Tuesday mornings!
“… Economists call this the “annuity puzzle.” … One reason is that those who buy annuities and die early end up subsidizing those who die later. …”
No puzzle, all sounds perfectly rational to me.
Retire and die early? Why would I want to subsidize unrelated retirees and give the insurance company a cut of my lifetime of savings?
Retire and die later than projected by life insurance company actuaries? Well, the value of the mortality credit is likely to be minimal given widespread, extensive adverse selection (private knowledge, healthy self selection, etc.) which must, by definition, force the insurance company to lower the “money’s worth” of the annuity. Data confirm people who expect to live longer are much, much, much more likely to buy annuities. Because take up rates are sooooo low, typically < 10% for a single premium immediate annuity (SPIA), adverse selection is widespread and insurers raise prices in response, adding a very conservative load for anti-selection.
Retiree response? Doesn’t look like a good deal! Many are willing to forego what is likely to be a minimal mortality credit, received starting in the mid- to late 80’s. Many prefer taking that chance of living longer, and adapting as necessary.
Consider this study (now ten years old) of those 15+ years into retirement:
“… most people adjusted well to their financial circumstances and modified their spending as their major financial planning tool. Their main approach to risk management involved little planning; rather they sought to adapt to any
circumstance that arose. …”
See: https://www.soa.org/globalassets/assets/files/research/projects/research-2015-focus-group-report-final.pdf
Finally, why do people say they prefer the monthly income from a traditional defined benefit pension plan that doesn’t have a lump sum distribution option? Obviously, they don’t recognize the cost of mandatory annuitization because there isn’t any pricetag.
And another thing! On financial websites people routinely discuss buying an annuity OR using drawdown. So I intrude to point out that nothing stops you doing both.
This means that people who witter endlessly about “diversification” in their years of accumulation of capital propose to ignore the idea for their years of decumulation. There’re words for that in English. Dim-witted, mutton-headed, …