When to buy an annuity: Getting choices right at and in retirement

22nd July 2022

One of the most significant impacts of Pension Freedoms was the rapid fall in the number of annuities being purchased at the start of people’s retirements. Up until April 2015 over 90% of those accessing their DC assets at retirement did so via an annuity purchase.

However, within a year of the new choices at retirement coming in, the annuity market had lost three-quarters of its value! Numbers of annuity policies sold annually dropped from 466,000 in 2009 to just 49,000 in 2020.

However, there has been renewed interest in buying annuities in the last two years.

Is there a right time to buy an annuity?

This is worth investigating as it suggests there is real value (for those with large enough pension pots at least) in considering hybridisation of retirement income i.e., buying a combination of income drawdown and annuity or starting in drawdown and then moving into annuity after several years of retirement.

Back in November 2021, the pensions experts Lane, Clark & Peacock published a seminal paper called ‘Is there a right time to buy an annuity?’, exploring the optimal ‘crossover point’ i.e., the age at which it makes most sense for retirees to buy an annuity with what they still have left in their drawdown plan.

It involves complex modelling including 4 key factors:

Level of investment risk taken in drawdown (from 55% up to 100% investment in equities).
What percentage drawdown rate you want to take from your drawdown policy each year of retirement.
Whether annuity you purchase is flat or index-linked.
How much you value leaving an inheritance to your heirs.

But the key finding is that somewhere between age 65 and 75 that crossover point is reached for pretty much everyone!

The same paper also indicates that a hybrid approach in which, from day one of retirement, you use a percentage of your total savings to purchase an annuity, perhaps demarcated to cover ‘must have’ living expenses for example, while other retirement savings remains held in growth-orientated assets in income drawdown thus delivering retirement income which pays for more variable ‘lifestyle extras’ such as a new car, new kitchen, a child’s wedding, or a second holiday.

In terms of implications for pensions products and policy change, Lane, Clark & Peacock asserts that one approach is for products to be developed which start out in drawdown but are set up to switch to an annuity automatically at a later stage, with the exact age depending on the saver’s preferences. That switch to an annuity could happen ‘by default’ but policyholders could retain the right to change their mind before that date. All this might happen following a ‘mid-retirement MOT’.

These are all good ideas and leave us with clarity that product innovation is definitely needed in an increasingly DC asset-dominated world, if people are to optimise their retirement income and happiness.

If we get decumulation choices right then the vision of Pension Freedoms & Choice will finally be fully-realised – at least for those who have built sizeable pots during their working lives.

Read our Baby Boomers Report here