Roughly 90% of defined contribution (DC) savers in the UK still buy fixed-rate immediate annuities at retirement. Does this make sense for UK workers, and is there a lesson to be learned for the US?
Private sector pension systems in the US and UK have undergone significant structural changes in the past decade, with an increasing reliance on DC programs to help individuals fund their retirements.
While the two systems take similar approaches to helping individuals sign up and build savings, they take nearly antithetical approaches to retirement income. US retirees traditionally draw down their savings over time, whereas UK workers traditionally purchase a fixed-rate immediate annuity at retirement.
Rule changes over the last decade have relaxed the legal obligation on UK retirees to buy a traditional annuity at retirement, but about 90% of them continue to do so. Does this make sense for UK workers—or workers in the US? Advocacy of fixed-rate annuities for plan participants has risen sharply in recent years.
We firmly believe that the guaranteed income for life offered by an annuity is highly desirable. However, the risks associated with the current market favorite in the UK—a level annuity that ceases immediately on the death of the purchaser—should come with risk warnings attached, as my colleague David Hutchins explains below.
Let the buyer beware
Having spent recent years speaking to UK retirees who have recently bought annuities, we believe there is a clear need for better warnings about their drawbacks, as well as their benefits. Here are a few ideas about the warnings we think would be useful—and why.
This annuity will not protect you from inflation. The vast majority of annuities purchased today have no inbuilt protection against inflation. Consider this: for someone retiring at age 65, inflation of 5% a year (somewhat less than today’s UK level) would reduce the spending power of £1 to 61p by age 75 and to a mere 38p by age 85. The only way retirees can shelter their income from such depredations is to accept a much lower annuity rate at the outset.
This annuity may seriously damage your family’s wealth. The large majority of annuities purchased today provide no benefits to the surviving spouse on the death of the purchaser. It is clear from this that most savers do not know there is a 60% probability that one member of a couple will outlive the other by at least 10 years in retirement.
This annuity is a lifetime commitment ‘til death do us part. Most of those buying annuities—often in haste when they retire—may be forced to repent at leisure. Once purchased, a buyer is tied to that annuity for life: the terms cannot be changed nor the contract surrendered.
The “best” rate may not really be the best for you. As pointed out in the previous few paragraphs, individuals rarely purchase annuities that provide protection against inflation, benefits for spouses or revocability. Why? Indiiduals tend to gravitate toward the option that provides the highest current income for their situation today.
This annuity may be a lot more expensive than you think. Unlike most modern financial products, annuities do not make clear what the purchaser is paying for; this makes a cost comparison with the alternatives far from fair. Typically, buyers can expect to hand over 10% to 20% of the cost of an annuity to the annuity provider and its distributor.
Let me be clear: Traditional fixed annuities do have some genuine benefits. The lifetime income guarantee they provide is not something to be dismissed lightly. Yet, given the very high probability that someone retiring today at age 65 will still be alive at age 75, why do so many UK pensioners rush to buy an annuity when the benefits of delaying such a purchase can be substantial?
Making the purchase less hastily gives the purchaser time to better understand what they are buying. It also gives purchasers time in retirement to understand their retirement needs, which positions him or her to make a more informed choice. Moreover, keeping their retirement assets invested for a longer period of time may help them better manage issues such as inflation, protecting the wider family’s wealth, “purchaser’s regret” and market pricing.
In sum, we favor a two-pronged approach to retirement income in the UK, which can also inform developments in the US:
• More information for annuity buyers, particularly about the risks, and
• Development of more flexible, lower-cost and better risk-managed strategies, including insurance-backed vehicles, to provide effective alternatives to traditional fixed annuities
Both approaches would allow people to make better choices.
The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.
Seth J. Masters is Chief Investment Officer for Defined Contribution Investments and Asset Allocation at AllianceBernstein and Chief Investment Officer of Bernstein Global Wealth Management, a unit of AllianceBernstein, and David Hutchins is Head of UK Defined Contribution Investment Research & Design, also at AllianceBernstein.