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Can De-risking Stock Market Volatility By Buying An Annuity Ever Make Pension Sense?

written by Bella Palmer
pension

Investors approaching retirement are probably somewhat justifiably nervous about the impact market volatility might have on their budget as a pensioner. Many will have breathed a sigh of relief when the recent bear market sparked by the coronavirus sell-off in March turned out to be the shortest in history. But pension pots invested exclusively in UK stocks, will still be around 20% of their values of several months ago.

And pension-funding investors will understandably still be wary of a ‘double dip’ for stock markets as a second wave of the Covid-19 pandemic gathers strength and new lockdown measures are brought into force.

An annuity is an investment product which offers a guaranteed income for either life or a defined period, such as 20 years. But as always, reducing risk comes at a cost and the guaranteed income an annuity provide represents a much lower return on investment than historical average annual returns.

The cost of de-risking pension income with an annuity has also increased in recent years alongside falling interest rates and strong stock market returns. Savings and fixed income investments becoming less attractive has pushed more investors, private and institutional, into risk-based investments, especially equities. Which has boosted the stock markets in a virtuous circle.

But what happens if all that cheap money swilling around stock markets in recent years has artificially driven values up to unsustainable levels? Isn’t there a danger they might suffer a hard landing at some point? And if they do, my pension will take a battering. Would it make sense to lock in the returns of the past decade now, or at least some of them, and use the money to buy an annuity and stop having to worry about stock market volatility?

It’s certainly a question that makes sense to ask. But with annuity rates also at historical lows this year, is the price of a low risk annuity pension provision too high to make sense anymore?

Experts say there are two major factors to consider when calculating the benefit to cost of annuity income. And they are currently pulling in opposite directions. The first is annuity rates, which have fallen steadily this year, and in the years leading up to it, along with interest rates.

Billy Burrows of the pension specialists Better Retirement Group, calculates that in January of this year, a couple aged 65 and 60-years old buying a joint annuity with two-thirds payable in the event of one of the couple surviving the other, would have been able to secure a rate of 4.19%. That means a £100,000 pot would have purchased an annual payout of £4190.

Compared with average compounded returns from a FTSE 100 tracker at somewhere around 6%, there’s an argument it might make sense to give up a 2% or so upside for security and piece of mind.

However, by April of this year, the best annuity rate available on the market for the same product had fallen to 3.293%. That would provide an annual annuity payment of £3293 for the same £100,000 pot. That’s inched back up to £3900, but the trade-off is still looking significantly less attractive than it did 9 months ago.

But over the same period, holding a £100,000 pension pot in equities would have led to losses. A typical equities-based pension pot held in a standard mixed investment pension fund would have fallen in value by over £15,000 between January and April to £84,088. The good news is it would since have recovered to back to over £96,000 this month.

That’s still a 3%+ loss, compared to 2%+ gain if an annuity had been purchased in January.

Will Annuity Rates Rise In Future?

Unfortunately, for those approaching retirement over the next few years, the chances of annuity rates significantly increasing again don’t look good. Interest rates look set to be held at rock bottom for the next few years at least. So 3%-3.5% annuity rates could well be the best case scenario for savers willing to trade their risk-based investments for a guaranteed return.

The second factor pulling in the opposite direction and favouring an annuity is the risk of another drop in share prices. Some analysts are concerned investors have paid too little attention to the real impact of the Covid-19 pandemic on the underlying economy and it hasn’t been properly priced in to current stock market valuations.

So far markets are somewhat ignoring drops in 2020 revenue and focusing on forecast revenues in future years. Treating the Covid-19 pandemic as a one-off force majeure and focusing on the underlying strength of companies under normal conditions has benefited public companies and helped prevent a bad situation from becoming worse.

Many companies have tapped investors for cash through new share issues and debt financing to see themselves through to a return to normality. Doing so would have been more expensive if share prices had collapsed and failed to recover quickly. That would have led to a heavier hangover, quite possibly stymying future growth potential by tying up capital that could otherwise have been invested in growth.

If the economy bounces back quickly in 2021 (new lockdown measures mean late 2020 doesn’t currently look good economically), stock markets should too, even if they slide again at the end of this year. But if unemployment rises significantly towards the end of this year as government support is tapered, and takes time to recover, that will amplify Covid-19 pandemic revenue drops by dragging them out for some time after the pandemic itself is no longer an issue. There’s little benefit in lockdown and social distancing measures ending if buying power has been hammered.

If that scenario unfolds, stock markets that have so far been let off lightly by the unexpected and mitigating circumstances of the pandemic could be set for heavier falls that take much longer to recover from as reality hits home. Even new rounds of quantitative easing flooding markets may not be enough to prop stock prices up.

Neither scenario, guaranteed but miserly income from a low-rate annuity, or the risk of a pension pot dropping by 10%, 20% or more if stock market values plunge, sounds especially attractive. Which is certainly a problem for those planning impending retirement.

The best option is probably to, if possible, hold off taking a decision. You could buy yourself time by holding a few years of living costs in cash. Or cashing in the value of a annuity but holding off on the decision to actually buy one. That money could then be either put back into equities in the future, or invested in annuity if stock market volatility continues for a longer period of time, or a recovery is slow.

Historically, annuities have never proved the better choice for returns from a pension pot over 20 years of retirement, compared to keeping the cash invested in markets. But that doesn’t mean that will always be the case. The risk that stock markets will spend 10 years in a depression seems low, unless the global economy and financial markets change in nature entirely.

Which means, overall, nervous savers might consider instead making sure they have enough cash to avoid drawing down from equity-based pension assets during market downturns. And putting their faith in the likelihood of stock market cycles roughly continuing in the same way they historically have. It’s not guaranteed returns. But the risk to reward ratio seems, at least to this writer, in favour of that approach as an alternative to an annuity.  

Important:

This article is for information purposes only.

Please remember that financial investments may rise or fall and past performance does not guarantee future performance in respect of income or capital growth; you may not get back the amount you invested.

There is no obligation to purchase anything but, if you decide to do so, you are strongly advised to consult a professional adviser before making any investment decisions.

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