Advisers with drawdown clients should be assessing in their annual review whether some of their portfolio is used to buy an annuity, especially as clients get older, argues Better Retirement director Billy Burrows.
This week, actuarial experts Milliman, supported by specialist annuity provider Just, published research that framed an annuity as an asset class.
Entitled Annuities reinvented: Are annuities the missing asset class for sustainable drawdown solutions?, the paper suggested that using an annuity and equities mix can provide a better outcome, not only in terms of maintaining a target annual income but also in providing a higher average death benefit.
Though the consultancy said the latter finding is somewhat surprising.
The scenario
In conducting the research, the consultancy modelled the behaviour of an annuity/equity strategy and a bond/equity approach, both with a cash element, across 1,000 economic scenarios with varying inflation and investment returns.
It selected the underlying investment as follows: 5% in cash, 55% in equities and 40% in either bonds or an annuity.
The annuity/equity strategy offered approximately a 66% chance of meeting her target income in every year of retirement
It assumed an overall annual fee of 1% on the drawdown funds to cover the fund management and platform charges, but with no adviser fees. Commercial annuity rates were used to model the annuity/equity strategy.
A wide range of customer circumstances and preferences were modelled, by varying proportions of equity, cash and bonds/annuity, target income requirements, customer age and health. Though the report, sponsored by specialist annuity provider Just, made no allowance for tax paid.
100% guarantee
Burrows said: “The argument is dead simple. If you are running a portfolio of 60% equities and 40% bonds, then you could think of using some of the bonds to buy an annuity.
“First of all, the underlying yield should be higher as they invest in all sorts of different things. You also have the mortality cross-subsidy and there is no default risk. If you buy your own bonds you could lose your shirt, but if you are in an annuity it is 100% guaranteed.
“The research confirms my view that for most people in drawdown, as they get older, it is to their advantage to buy into annuities. It is all part of the de-risking process.
“That is down to the quality of the advice. Good advisers will be thinking about this and, as part of an annual drawdown review, should be looking at when is the time to buy annuities.”
He added that it may even become customer-driven over time as the risks of drawdown become clearer.
Meeting target income
The analysis examined a 65-year-old woman looking to take an annual income equivalent to 4% of her retirement pot, which moves in line with inflation. By combining a level annuity with an equity drawdown fund, the portfolio increased the likelihood of maintaining her target income until age 100 from 45% to 55%, compared to a drawdown fund investing in equity and bonds.
It found that if the female retiree lived to age 95, the annuity/equity strategy offered approximately a 66% chance of meeting her target income in every year of retirement.
However, for those who proved less long-lived, the bond-equity strategy was equal to or better than the annuity/equity strategy.
The analysis showed that for the first 12 years of retirement, a retiree would be able to withdraw her target income regardless of whether she chose to invest in bonds or an annuity.
Indeed, that was the case in every one of the 1,000 economic scenarios tested.
Advantages for longer-lived
After 12 years the bond-equity strategy performed better, but after 25 years of retirement the annuity/equity strategy had a higher likelihood of meeting the target income.
The bond-equity strategy still offered a higher likelihood of meeting the retiree’s requirements in the early stages of retirement, but this decreased more steeply after 20 years of retirement.
The prospect of the annuity/equity strategy meeting the target income decreased more gradually. So, if the retiree lived for 25 years or longer, the annuity/equity strategy provided a better chance of being able to meet her target income for the duration of her retirement.
If she enjoyed a 30-year retirement, the annuity/equity strategy had a 66% chance of providing her with her target level of income throughout retirement, while the bond-equity approach had a 63% chance.
The analysis said that, while this could be considered a modest difference, the three percentage points of difference represented 30 extra economic scenarios where the target income requirement would be met under the annuity/equity strategy while no income would be received under the bond-equity option.
The difference became more pronounced with age. If she enjoyed 35 years of retirement, the annuity/equity strategy had a 55% chance of providing the target level of income whereas the bond-equity strategy only had a 45% chance.
There was a 67% likelihood that a healthy 65 year-old female would still be alive at 90. For men, the report said there was a 57% chance.
Death benefits
In terms of death benefits, the paper added that at around 21 years into retirement there is a cross-over point where the average of the combined value of the drawdown fund and cash account under the annuity/equity strategy began to exceed the corresponding value under the bond-equity strategy.
This meant that the average death benefit was higher for the annuity/equity strategy than for bond-equity. If she survived for 30 years into retirement, then the average death benefit under the annuity/equity scenario was approximately £55,000, whereas it was about £40,000 using the bond-equity strategy.
