Global financial markets have weathered many storms over the last few years with the most recent resulting from the war in Iran. Each time there has been a financial shock markets have bounced back. At times like this investment firms send out their ‘don't panic and stay invested' messages and most of the time this is sound advice.
But what will happen if there is a storm so powerful that markets do not quickly recover? Investors will be nursing huge losses and financial plans will be left in ruin and those approaching retirement or already in retirement may find themselves in a precarious situation as time is not on their side.
Although we cannot predict the future, we can plan ahead and the current global uncertainties highlight the importance of de-risking investment portfolios and retirement plans as clients grow older and have a lower capacity for loss.
There is not much you can do in the eye of the storm but when the storm blows over, there are a number of planning opportunities to de-risk and make sure clients are in better shape for the next storm.
Annuities are my specialist subject, and understandably, I think annuities have an important role to play in helping to de-risk retirement plans.
As the chart below shows, advisers and their clients need to keep one eye on annuity rates and one eye on financial markets. Annuities are now back to pre-2008 credit crunch levels and despite several financial shocks, the FTSE 100 reached record highs just before the Iran war.
Annuities can be thought of as either an insurance policy which insures people do not outlive their income and assets or as investment plan that delivers guaranteed returns.
The advantages of guaranteed returns should be self-evident but a lot of people still don't like annuities and it was eloquently articulated by Lord Grantley speaking in a House of Lords debate on pensions in October 1997 when he said: "In my view, there are two overwhelming reasons why people should not invest in annuities under any circumstances. The first is that investing in annuities is contrary to the interests of a family . . . in that they are worth nothing when the investor dies. The second reason is simply that annuities are a lousy form of investment."
The key to demonstrating the advantages of annuities is to address these two criticisms head on.
Most people who have a spouse or partner will arrange joint life annuities thereby ensuring when the investor dies income continues to their nearest and dearest. One of reasons why annuities are held in low regard is that people tend to underestimate their life expectancy. The standard life expectancy tables show a man aged 65 can expect to live for another 20 years to age 85, and there is a one in four chance of living to age 92. For women, it is 88 and 95.
To fully appreciate the advantage of income for life, it is necessary to look at the alternative which is some form of drawdown. With long term yields over 5% it means the underlying rate of return from an annuity is also about 5%. The income for a £100,000 joint life annuity, two-thirds paid to surviving spouse or partner and with level income for ages 65 and 60 is currently around £6,850 per annum gross. This is part return of capital and part interest.
If the same income is taken from drawdown then logically, the pension fund must grow by at least 5%, plus an extra margin to allow for the absence of the mortality cross subsidy and for charges. If this is at least 1%, then it is reasonable to expect investment returns over 6% over the longer term at a time when people should be taking less risk not more.
Turning to annuities as an investment, it has long been argued that annuities should be regarded as another asset class and replacing the bond element of a portfolio with an annuity can lead to better outcomes.
This is true for lifetime annuities as they can maximise lifetime income in a way that drawdown cannot. It is even truer for fixed term income plans/annuities.
There is an interesting debate about whether fixed term is an annuity or a subset of drawdown. With a fixed term plan, there are two variables; the term and amount of income paid and these determine the final maturity value. Although there are many different options, the most popular term is five years and there are three common uses:
- Income similar to a lifetime annuity with reduced maturity value
- All income paid out so there is no maturity value – cash out plan
- No income but maximum maturity value
At present, there is a lot of interest in the third option. £100,000 invested in a five-year fixed term plan with no income will guarantee to payout about £128,000 in five years and this is fixed and guaranteed return of just under 5%. As one retired investment professional told me, where else can you get such a high guaranteed return for the next five years.
Conclusion
It is at times like this when an unexpected event causes severe market volatility that we are reminded of the importance of de-risking, especially in later life.
Don't forget, it is not only investment risk you must consider, there are many other risks including risk to income, inflation, health and longevity.
There is no single solution that effectively hedges against all of these risks so a combination of options should be considered including annuities.
William Burrows is founder of the Annuity Project and financial adviser with Eadon & Co
About the author
William Burrows