Today I thought I’d write about investment linked annuities which are becoming more popular now because level (standard) annuity rates are so low due to Government gilt performance, and inflation threatens to substantially weaken the spending power of future annuity incomes.
Traditionally, most advisers suggest to clients a choice between income drawdown or a fixed rate annuity. However, both choices have issues that can’t be brushed over in the current uncertain economic climate.
First, as mentioned above, because traditional fixed rate annuity rates are rock bottom now, even a guaranteed income for life may not yield very much when the true spending power of that money has been eaten away by inflation.
Secondly, choosing to go the route of income drawdown (your pension pot is invested and you draw income from it) means that your capital itself is at risk, just when you were hoping perhaps to be able to stop worrying about it. Income drawdown is certainly more risky, but remember potential returns means your income could be higher.
Now, this unpredictability may or may not suit you depending on your attitude to risk, but you could find yourself drawing down more money than your fund is making because your investments go down rather than up—thus you begin eating away at the very asset that gives you the retirement income in the first place. If your investments do take a dive, you could run out of money before you die.
Traditionally, drawdown is offered to those with larger pension funds, and have alternate sources of income in place to live on should losses occur, whilst a standard annuity is often offered to those with a smaller pension fund (£50,000 or less). This means these pensioners will not run out of money, yet their income may be much smaller than past generations enjoyed for the reasons mentioned already.
So what to do?
Well, firstly buying an annuity that increases income annually is probably not the best answer because you must start with much lower initial incomes—approximately £3300 (increasing annuity [Pru]) v £5500 (standard or level annuity [Aviva]) or so for a 65 year old and a £100K annuity.
Instead you could consider…
Investment Linked Annuities
The main benefit they give you, is that ideally you stand to get the best of both worlds; ie you get the potential of your income increasing if your pension investments rise in the markets, yet on the other hand if they do crash due to a badly performing stock market, then you will still get a guaranteed minimum income for the rest of your life.
In the past this minimum income level was low, but because standard annuity rates have dropped so much, the differences now are negligible, making investment linked annuities a much more attractive proposition these days.
These type of annuities give more flexibility because you can choose between 50-120% of their income—for example for an income offer of £5,500 a year you could take £2,750 or £6,600. (The more you take the more the investment risk of course).
With this type of annuity your future income will be based on how well the investment you have chosen performs. Therefore you must be comfortable with certain levels of risk to begin with.
(Conversely, it is equally important to consider that defaulting to the majority choice of purchasing a standard annuity carries a risk in itself. This is because in future, inflation could significantly reduce your income in real terms because standard rates are so low now.
In short therefore, there is a risk for all annuities; standard, investment linked or if you choose drawdown and don’t buy an annuity—with all options you must consider which type of risk you are most comfortable with).
There are two main types of Investment-linked annuities…
With Profits
Your income is linked to how well the annuity provider’s with-profits fund performs and returns are balanced to smooth out peaks and troughs in them in order to provide the pensioner a more consistent income.
Unit Linked
With these your income is linked to the funds you choose to invest in. You will be given a choice from a range of different funds containing different investment assets.
There is a greater potential return with unit linked investment annuities but there is also greater risk too, because unlike with profits funds, they are directly linked to the performance of the fund. This means that if there is poor performance one year, then that will be reflected in your income immediately with no smoothing as in with profits funds linked to your annuity.
However, if you have alternate sources of income that can offset these sorts of peaks and troughs, and are comfortable with an element of risk, then unit linked investment annuities may be a good match for you.
So to sum up, let me just reiterate, the main benefit of choosing an investment linked annuity is that you get pretty much the best of both worlds; you get a guaranteed minimum income level, as well as the opportunity to enjoy a higher income from the investments your annuity is invested in.
So finally, who are investment-linked annuities best suited for?
- If you want a fairly high starting income yet with future growth potential
- If you are concerned future inflation will erode your income from a standard annuity
- If you have sources of income, pensions or capital to fall back on if your with-profit income drops
- If you have applied for an enhanced annuity because of poor health
- If you are fully understand the risks and are comfortable with them
There we are then, that’s enough on annuities for now—the sun is shining and it’s time I went for a well earned breather! If you do want more reading, check out this page on the basics of annuities here. And of course if you want to talk instead, call me free from a landline at 0800 321 3508 or direct to my mobile : 0757 679 1009, I’ll be happy to help.
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William George has been a Financial Advisor since 1993. From Dunfermline, Fife in Scotland, he services clients across UK, as well as expats from as far afield as New Zealand. He also has appeared on BBC Radio Scotland discussing investing and specialises in helping people with Retirement Planning and Pension Advice. Google+
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