The Value for Money of Annuities and Other Retirement Income Strategies in the UK

Abstract

An annuity is an insurance contract where a person (the annuitant) pays a premium upfront to obtain a stream of future payments until his or her death. To assess the value of an annuity, we calculate the ratio of the expected present value of annuity income to the annuity premium − this is known as the Money’s Worth (MW). The MW takes into account the expected average longevity of annuitants and the interest they forego on their pension pot by buying an annuity. Using this approach, our findings are that i) on average between January 2006 and June 2014, an annuitant with a £50,000 pension pot can expect to receive back 94% of the premium paid when purchasing an annuity in the open market. MW is reasonably stable over this period, ii) annuities bought with smaller pension pots give proportionally worse value, iii) annuities bought on the open market give better value than annuities bought from the pension accumulation provider and iv) the fall in interest rates and increase in life expectancy has had a significant impact on annuity rates. We also compare the income generated by an annuity to selected alternative ways in which the pension pot can provide a retirement income, whereby a retiree has flexibility in how much income he or she can draw at any point of time during retirement. Such strategies may be available in the future, given the greater flexibility allowed by the 2014 Budget announcement. Our results suggest that an annuity gives good value for money when purchased using the Open Market Option compared to other strategies, because annuities allow a relatively high level of consumption while protecting the retiree from exhausting the pension pot. We find that where retirees do not accept investment risk, the income available to consumers is greater from an annuity rather than from the alternative strategies, apart from one strategy that comes with a significant risk that the retiree exhausts their pension pot. If retirees are willing to invest in risky assets, they may achieve higher levels of consumption than under an annuity; however, they also have to bear additional risk of exhausting the pension pot.