Stories | September 29, 2015

Should you buy an annuity?

Common thinking traps can easily affect our retirement and pension options.

When it comes to retirement,  professional advice usually focuses on saving as much as possible. But many of us may struggle to save – perhaps because of low wages, or time spent away from work – while others save too much. Buying an annuity when retirement approaches is one way of ensuring you’ll have an income in perpetuity.

Live long and prosper
The idea with annuities is that worries about outliving your savings can be reduced by investing in a regular income stream that will be paid out for as long as needed. The choice, however, can be contentious, and annuities might suit some people more than others. Statistics suggest that people have at times been reluctant to buy into the annuity concept.

Thinking about the future
Top behavioural economist Richard Thaler wrote a 2011 article for the New York Times explaining that annuities should be thought of as a form of insurance. “When offered the chance [to buy an annuity], nearly everyone declines,” writes Thaler.

This is partly about the paradox of choice, he suggests: when provided with a big range of options, many people become unsure how to choose. Studies support his conclusion. And in an eZonomics poll, 43% of people agreed that having too many choices makes it harder to decide.

It can even become easier to make wrong choices.

Worth a punt?
Another problem, Thaler writes, is that people see buying an annuity as a gamble. Yet, he points out, buyers of annuities tend on average to get more income for the rest of their lives than those who self-manage pension savings. “One reason is that those who buy annuities and die early end up subsidising those who die later,” Thaler explains.

Because the situation is uncertain anyway, we may worry that we’ll lose out – especially if there have been news reports about people getting ripped off by one scam or another.

Present view bias
Media, however, generally highlight unusual situations, not what most commonly happens. Instead, imagine what benefits may be lost if action for retirement is not taken. Visualise where you might be in 30, 40, or 50 years, and what might be required. Perhaps even take a photo to help you, as this article suggests.

You can even write a letter to your future self here.

Compare and contrast
People typically don’t find it easy to do the maths involved with annuity calculations. Interest rates have been poor in recent years, which means returns on a range of investments, including annuities, have fallen. Fees and charges, which can really add up over time, must also be considered. But we’re living longer generally, while the kinds of pension schemes that used to guarantee retirement income are now rare.

Instead, most people will typically need to compare a range of investment options, including various types of annuity, against different levels of risk and ultimate return.

You’re worth it
In the UK, a 2014 Financial Conduct Authority (FCA) review recommended making the effort to shop around and consider all the options. “We found that 60% of consumers were not switching providers when they bought an annuity, despite the fact that around 80% of these consumers could get a higher income on the open market, many significantly so,” the FCA wrote. Even small amounts can make a difference long term, especially once compound interest has been factored in.

If the decision really does get difficult, consider using the services of a professional financial adviser. Your future self may thank you.

eZonomics team
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