Following the end to compulsory annuitisation in the budget, is everyone who can afford it going to take their pension pot and become a landlord? The argument that they will, which you will find on plenty of websites offering financial advice, goes as follows. First, you get a good return in the form of rental income relative to annuity rates. Second, you get to pass on the property to your children, rather than losing all your capital.
There is one important point we need to get out of the way first. Comparing rates of return from being a landlord to annuity rates is misleading, because the risk characteristics are different. A much more sensible comparison is to compare returns from being a landlord to investing in the equity market, or to compare annuity rates to rates of return on safe assets. And if you think that house prices are bound to trend upwards and so carry no real risk, read this from Tim Harford.
The more interesting issue, however, is what happens to the insurance value of an annuity if an individual (lets call them George) can afford to live off the income from their capital and plans to pass on the capital to their children. Recall that for those who are not lucky enough to be as rich as George, an annuity is useful because it insures against the risk that they will live longer than their age group and might otherwise run out of money. However, if George has enough capital to live off the income from it, what point is there buying an annuity?
The answer is that it insures George’s children. Compare two plans. In the first (plan A), George invests all his pension in some form of asset, and lives off the income. In the second (plan B), George uses part of his capital to buy an annuity that gives George the same retirement income. As long as we stick to safe assets, annuity returns are bound to be higher than interest returns, because you never get the capital value of the annuity back. So under plan B George, having bought his annuity, will have some capital left. Plan B involves giving the capital left over to George’s children, now.
Both plans are designed to give George the same retirement income, however long George lives. Does plan B mean George’s children get less inheritance? No, because under plan A they only get the inheritance when George dies, but under plan B they get it now. So they can immediately invest George’s gift, and let the interest on it accumulate (rather than have George spending the interest). By the time George passes on, the value of their inheritance could well have grown to equal the value of the inheritance under plan A. [Under various assumptions it will. Which turns out to be better in practice depends also on the particular relationship between gift taxes and inheritance taxes that apply in the country George lives.]
The other important point is this. Under plan A, the date on which George’s children can access George’s inheritance is uncertain - it depends on how long George lives. Under the second it is not - they can access it at any time. So what an annuity does in this case is insure George’s children against the risk that George will live for a long time, meaning that it will be a long time before they get their inheritance. The insurance value of the annuity is not lost, but transferred from George to his children.
One final point. The idea that George’s inheritance would be equal the full value of George’s pension sounds as if George is being very generous indeed. (I’m assuming here that George has no other wealth - what made you think otherwise?) Put it this way. George’s pension is a result of his saving part of his hard earned money. If he gives it to his children, and they happen to retire just when George dies, they too can live off the interest - which means that they do not need to save for a pension of their own. So they seem to be a lot better off than George thanks to George’s generosity.
Now of course what I’m doing here is being a typical economist, which is trying to answer a question by asking what rational people would do in a world without imperfections, where arbitrage across assets holds etc. And, also being an economist, I found my analysis interesting in its own right. But as to what people in the UK are going to do with their new found freedom, in a situation where investors are supposedly buying up flats in London and not even bothering to rent them out, who knows.
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