Title: The Risk Paradox

Author: Billy Burrows

Added on: 06/05/2010

Last week the website www.thisismoney.co.uk ran a story about how much money people need to have saved by the time they reach  retirement and it was a staggering £600,000.

In the same article I was quoted as saying “One of the ways you can make your pension work harder is to take on a little more risk by putting some of your pot towards an investment-linked annuity”. This caused a number of readers to comment on how wrong they thought I was. They made the point that equities can go down as well as up and why would anybody want to take risk with their annuity?

I replied with three important advice issues. First investment backed annuities, including with-profits annuities, are only suitable for those with other sources of income to fall back on if the future annuity income was to fall. Secondly investors must understand and be comfortable with the risks and finally investors should not necessarily put all of their eggs in one basket therefore perhaps investing in a combination of guaranteed and investment linked annuities.

The more I comment on investment linked annuities the more aware I am of what I call “the risk paradox”.  Put simply many retired investors might have to take some risk with their annuity income in order to end up in a less risky position.  The keys to understanding this paradox are longevity and inflation.

The longer people live the more their annuity income will be eroded by the effects of inflation. Someone retiring at 60 may well have an annuity in payment for 20 years but at this point the spending power of a level annuity will have halved if inflation had been 3.5% each year.

With few people investing in inflation linked annuities because they are so expensive with the starting income starting about 40% lower than the level annuity, there is only two way s for annuitants to hedge against inflation.

The first is to buy a level annuity in the full knowledge that the spending power will reduce but they can make up the shortfall by using income and capital from other sources, perhaps equity release. The second is to invest in annuity which provides the potential for future income growth albeit with some risk.

I will finish on a note of caution, especially as having been an expert witness in cases involving the selling of investment linked annuities I am very aware of how it can go wrong.  Those advising on products such as investment linked annuities must show that they have followed a complaint and TCF advice process. This means that advisers will need to demonstrate that they have fully explained how these annuities work and have explained the risks in a way the customer understands. They must know their client’s retirement objectives and personal circumstances and finally they must ensure that the recommendation is suitable for their client’s circumstances.

The good news is this is not as hard as it seems if advisers invest some time in understanding the key issues in what I believe will become one of the most important areas of retirement income advice.