They protect us from two big risks.
One is investment risk. Of course, annuity rates are low. But this is largely because gilt yields are low. (This is not expected to last; the OBR foresees them rising by a full percentage point over the next four years, in line with the market’s expectations – but let’s ignore this for now.) And gilt yields are low because investors expect equity returns to be low and risky. History shows that such fears are often justified. Since 1870, there has been a significant positive correlation (of 0.38) between gilt yields – measured by yields on consols – and subsequent ten-year real returns on equities. Low annuity rates, therefore, point to low equity returns – which means that drawdown (the alternative to annuities) isn’t so attractive either.
Put it this way. A reasonable expectation for nominal equity returns would be for around 7.9 per cent a year. This comprises a 3.4 per cent dividend yield plus 4.5 per cent capital growth – on the assumption that share prices rise in line with nominal GDP. This means you could – on average – expect to take 7.9 per cent per year from an equity portfolio without eating into your capital.
But 7.9 per cent is exactly the annuity rate a 75-year-old could get now.
Of course, drawdown is superior to an annuity because you get to keep your capital. But doing so exposes you to the risk this will fall as shares fall. And this is a big risk; over a five year period there’s a roughly one-in-ten chance of losing ten per cent or more. This would give you the choice of either having a lower income than you’d get from an annuity or eating into your capital.
Granted, the latter is no disaster. But this brings us to our second risk – the danger that you might live long enough to outlive your wealth; over a longish retirement, it’s almost certain that an equity portfolio will suffer a big loss at some time. Annuities protect you from this danger.
Annuities are also a simple precommitment device. If we use drawdown, we might be tempted to spend too much too soon, and we also face the tricky problem of trying to calculate an optimum income in the face of the twin risks about longevity and investment returns. Annuities save us this faff.
Better still, they do so whilst offering decent value. So much so, in fact, that in a famous paper written in 1965 the Israeli economist Menahem Yaari suggested that someone who didn’t care about leaving a bequest should annuitize all their wealth.
Think of an annuity, he said, as selling insurance against your death. As long as you don’t die, you’ll pick up an insurance premium equivalent to the gap between the annuity rate and savings rates. In exchange for this premium income, you must pay out your entire pension pot when you die.
But here’s the thing. If you die – and don’t care about leaving a bequest – this loss shouldn’t bother you; as the saying goes, you can’t take it with you. An annuity therefore gives us the benefit of collecting a regular insurance premium without the worry of having to pay out. That’s a free lunch.
Now, subsequent thinking has slightly weakened Professor Yaari’s claim. But the gist of it still holds. Peter Diamond, a Nobel laureate at the Massachusetts Institute of Technology concluded one paper with: “A large fraction of wealth is optimally placed in a constant real annuity.”
In the US, this thinking has given rise to what economists call the annuity puzzle – the question of why so few people choose to annuitize their wealth when economic theory says they should do so.
Some believe that the answer lies in cognitive biases – subtle but systematic errors of judgement. One of these, says Marian Wrobel of Harvard University, is a framing effect. If people think of the annuity decision from the point of view of a spending frame, they favour annuities, thinking: “a regular income for life is a good thing.” However, many instead use an investment frame from which perspective an annuity isn’t so attractive: “if I die, I’ll lose everything.”
Another bias, says Shlomo Benartzi of the University of California Los Angeles is the endowment effect – our tendency to overvalue things simply because we own them. This makes us loath to part with our pension pot even if the exchange – a regular income – is a fair one.
All this poses the question: what, then, are the arguments against annuities?
The trivial one is that many of us want to leave bequests, and full annuitization prevents this.
Another is that buying an annuity is an irreversible investment; we can convert our pension pot into an annuity at any time, but we can't convert our annuity into a lump sum. And if we have the choice of whether to make an irreversible investment or not, we are - in effect - holding an option; because we can exercise it either now or later. And common sense - or real options theory - tells us that when we are faced with uncertainty we might prefer to hold onto our options rather than exercise them - which argues for not annuitizing.
But there’s a third possibility. It could be that a strategy of high drawdown early in retirement at the expense of a low income thereafter is not the reckless imprudence that some of Mr Osborne’s critics claim it to be but is instead an entirely rational thing to do.
One reason for this is that early spending builds up consumption capital – a stock of happy memories which comfort us in old age. In our 80s, we might look back fondly on the holidays we took in our 60s.
Another reason is that as we get older and less healthy we cannot enjoy our wealth so much; the marginal utility of consumption is lower if we are older and unwell. A holiday is not so much fun if we’re not as mobile as we used to be, and there’s no point owning a fast car if our eyesight is failing.
All this argues for us spending whilst we can – which favours drawdown over annuities.
There’s one further issue, though. It’s that Mr Osborne’s reforms could ultimately change annuities. The effect here is ambiguous.
On the one hand, greater competition from non-annuity products should force annuity providers to improve the quality of their products – not just by offering better rates but also more flexibility about the level of income or the chance to leave bequests.
On the other hand, though, there’s the problem of adverse selection. If people are entirely free to buy annuities the ones most likely to do so are those who expect to live a long time. And this expectation might be justified, given that we know more about our health than do annuity providers. As that great economist Jane Austen wrote, “people always live for ever when there is an annuity to be paid them.” Knowing this, annuity providers would reduce rates to protect them from their clients living so long.
It’s not clear which of these mechanisms will prevail. What is clear, though, is that annuities are not such a terrible deal. Even in a fully free market, retirees should seriously consider at least some annuitization.
