Are annuities puzzling?

The ‘annuity puzzle’ hints at a gap between economic theory, which suggests that annuities provide an optimal solution to longevity risk, and economic reality which shows annuities remain less popular than drawdown.

Despite an uptick in annuity purchases, commensurate with the improvement in rates, drawdown is still the product of choice for most people. The latest FCA data shows that 82,061 annuities were sold in 2023/24 (38.7%), compared with 278,977 drawdown sales¹.

Buying a lifetime annuity means people don’t need to worry about running out of money or managing their investments. They can focus on enjoying their retirement and spend their monthly income in the knowledge that it will be paid for life.

This should be a persuasive proposition and research appears to support this view. A Demos study revealed that people who annuitise are less likely to suffer from depression or feel sad compared with those who choose drawdown². These findings, between the degree of annuitization and happiness, were broadly mirrored in a US report from the Rand Corporation some years earlier³.

Why aren’t annuities more popular?

The lack of success in marketing annuities is not a UK phenomenon. The annuity market in the US and several other developed countries remains small⁴. Why might this be?

• Lack of flexibility. People value flexibility almost as much as they value certainty⁵. Annuities provide certainty but are inflexible. The income can’t be stopped or varied (escalating options aside). Nor can an annuity be encashed. And ad hoc lump sums aren’t available (which may make capital more attractive than income).
• Bequest motive. Annuities have historically been seen as poor value if the recipient dies early, though they now provide more flexibility on death. Guaranteed periods - often up to 30 years, value protection up to 100% of the purchase price (less payments to the date of death) and beneficiaries’ pensions. The announcement that pensions will be subject to IHT on death after April 2027 may have an impact on the attraction of annuities.  
• Underestimating life expectancy. People continue to underestimate how long they might live⁶. They may look to their parents to assess their life expectancy, but people are living longer these days. Average life expectancy is useful to track improvements across the population, but is much less effective in forecasting individual life expectancy.
• Availability bias. Comments like George Osborne’s ‘No one will have to buy an annuity’ are often used by people to make snap judgements. The behavioural economists call this ‘availability bias’.  The tendency to use information that comes to mind quickly and easily when making decisions.
• Framing. How a choice is presented affects the decision consumers will make. An example is the positioning of annuities. FCA research revealed that when presented as a form of insurance, 66% of consumers preferred an annuity to a savings account. When presented as an investment product only 17% chose the annuity⁷. 

People are often attracted to an annuity when the features are described⁸.  A 2023 survey found that, of the two in five (44%) pre-retirees who said they wanted a guaranteed income for life, only around half said they either wanted or are considering annuities⁹.

A way forward

There will always be people who value the certainty annuities provide and are happy to forgo the flexibility of drawdown. Conversely, there will always be people who welcome the flexibility of drawdown and are comfortable absorbing the risks of drawdown. Between these cohorts, there will be those who value both certainty and flexibility: They’re happy to take on some investment risk, but want a base level of secure guaranteed income. 

There is an increasing body of data to show that including a degree of annuitisation within drawdown can boost sustainable withdrawal rates and even provide higher death benefits over the long term^10,11,12. This strategy can also help mitigate sequencing risk. To facilitate this approach, companies are developing guaranteed income for life solutions that sit on platforms. Coupled with the planned change in the tax treatment of pensions on death, this could catalyse renewed interest in annuities. 

What’s more, the FCA thematic review highlighted the need to consider annuitisation as part of any decumulation process. Perhaps we’re on the cusp of a renaissance for annuities? You can find out more about this subject, and the benefits of an integrated solution, in our latest report Investment risk and retirement.