An annuity is a simple retirement payment option that guarantees to pay the owner a particular amount every month through their life in retirement. Once very popular, they fell out of favour in the noughties and the low-interest rate environment. However, they have been gaining ground as the prospect of interest rate increases looms on the horizon.
Oliver O’Connor, private client partner at Grant Thorton, points out that since the value of annuities is linked to prevailing interest rates that when these were exceptionally low so too were the annuity rates. However, some people had (and continue to have) annuity rates that were set many years ago and are therefore entitled to utilise such annuities irrespective of the prevailing interest rate now.
“The ‘value’ of an annuity has grown by virtue of interest rates rising in the recent past and it is likely that there may be another rate rise in the coming months. Therefore, the appeal of annuities is also increasing. However, another factor which people consider is their (personal) fear of having to make any investment decisions. By purchasing an annuity you will not need to make any decisions on investing funds,” says O’Connor.
Brian Codyre, senior financial planning consultant, Mercer Ireland, explains that they originally fell out of fashion through the combination of life expectancy and interest rates.
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“As interest rates have been very low or negative for the last number of years, annuity returns have also been low. For example, an annuity rate for a 60-year-old male on a joint life basis¹ was 2.87 per cent in February 2020. This means a pension valued at €100,000 after any tax-free lump sum is taken would provide a monthly pension of €240 for the rest of the annuitant’s life; when they die, their spouse would receive €120 per month for the rest of their life,” says Codyre.
The recent inflationary environment and rising interest rates have a silver lining for one cohort: individuals who wish to buy an annuity on retirement.
“If a 60-year-old purchased an annuity today on a like-for-like basis, they would receive a rate of 3.99 per cent, generating an income of €332 per month for every €100,000 used to purchase an annuity. While this may still seem low, it represents a 38% increase in the amount available two years ago.
“Most people will retire at 65. The current annuity rate for a 65-year-old, on the above basis, is 4.54 per cent, or €4,540 per annum for every €100,000 used to purchase the annuity,” says Codyre.
The primary upside of purchasing annuities is that they give certainty to the individual in terms of the future income they will receive.
O’Connor explains: “Where there is a spousal element to the annuity it also gives the spouse (should they survive the initial annuity purchaser) certainty on the amount of income they will receive following the demise of the person who initially purchased the annuity. The purchaser also has the option to include annual increases to the annuity payment in order to protect against inflation and the future cost of living.
“An additional upside is that, by purchasing an annuity, the individual does not need to give any consideration to the “investment markets” and whether they are growing or declining in any year or period. For someone who is at the retirement stage of their life and does have not any experience of investing in the markets, it can be quite a daunting prospect and therefore annuities give insulation from this — again taking away tough decision-making in complex investment scenarios.”
On the flip side, this inflexibility can put people off. As Codrye explains: “The main drawback is that a vanilla annuity dies with the annuitant, and there is no way for the next generation to inherit the funds. Some protection, such as a spouse’s pension or a guaranteed period of either five or 10 years, may be put in place, and while it is possible to take measures to protect against inflation, this will reduce the monthly pension. For instance, applying 3% per annum inflation protection reduces the annuity rate from 4.54 per cent to 3.51 per cent in the above example, meaning the annuitant would need to live for 17 years before breaking even.”
Overall annuities may be suitable for people who want certainty of income for the rest of their and their spouse’s life in addition to not running the risk of their pension in retirement falling in value.
Existing retirees who have an Approved Retirement Fund (ARF) may also consider using a portion of their fund to purchase an annuity that provides a specific income for the rest of their lives. This enables a minimum guaranteed income while retaining a portion of the retirement assets in the ARF to provide flexibility.
“If interest rates continue to rise, annuities will become increasingly attractive to retirees. This turbulence highlights how complicated the retirement journey can be and how important it is to get professional advice,” says Codrye.
O’Connor echoes this advice. “Typically annuities are provided for purchase by the larger life companies. The annuity rate on offer may vary slightly from company to company and it is therefore important to ensure that you know the exact details of the annuity before proceeding. By engaging with a financial adviser, they can help you identify the best rates on offer, while also quantifying the benefits of additional add-ons such as annual increases, spouse’s pensions and guaranteed periods.”