Why annuities are down – but not out
There’s never been a worse time to buy an annuity – a guaranteed income for life. Yet ironically, the reasons to want a guaranteed income have rarely been greater. So can they still be good value in retirement or not? Pensions expert Billy Burrows tells you what you need to know about annuities today.
Back in 2014 when pension freedom was announced, George Osborne said, ‘Let me be clear: no one will have to buy an annuity.’ With apt timing, annuities proceeded to have the roughest of rides – with their rates, sales and reputation plummeting all at once.
So has the dust settled, two and a half years on? Not quite. Annuities are still in pretty poor shape – but the good news is, things may at last be looking up.
Quick recap: What is an annuity?
An annuity is a financial policy that converts a lump sum (normally money from your pension pot), into regular income payments for the rest of your life (and your partner’s life, if it’s a joint-life annuity).
What’s gone wrong for annuities?
I’d single out two reasons for the poor state of the annuity market. Number one is that annuity rates are still at very low levels, due to low yields and low interest rates. Number two is that the annuity market has acquired a poor image and reputation, which if anything has worsened since pension freedom.
Why low interest rates = a poor deal
When you purchase an annuity, you give up ownership of a lump sum of money. In return, the insurance company will make regular monthly payments until you die. If you live longer than expected, you will get much more that you initially invested. However, if you die sooner then you may end up out of pocket.
The amount of income an annuity delivers will depend on several factors: the main ones are your age, your health and the investment return on annuity funds. The problem is that rising life expectancy has coincided with falling long-term returns, both of which drive annuity rates down.
Let’s say Bob is 60 and in good health. He could buy a gross annual single life annuity of £4,124 for a lump sum of £100,000. If he waited till he was 65, he could buy one of £4,764 for the same sum. These payments would be guaranteed for a minimum of 5 years even if Bob were to die before then.
But how does Bob know if that’s a good deal? Quite simple: we have to calculate how much would be needed to simply pay back that £100,000 over Bob’s life expectancy. Then we compare this to the annuity income payable now.
According to life expectancy tables published by the institute of actuaries, a 60-year-old man in good health can expect to live to age 87. A 65-year-old should live a few months longer (this may seem counter-intuitive, but it’s based on the fact that someone still in good health at 65 has a better life expectancy overall). So Bob at 60 can expect to live another 27 years, while Bob at 65 should live another 22 years (and a bit). Women are expected to live longer than men, though the gap isn’t as big as it used to be.
For the curious, here’s the full table:
Beware, there are a lot of numbers coming – but they will give you a real insight into whether or not annuities can still be good value.
Here’s what it would look like if Bob’s money (£100,000) was paid back over 27 and 22 years, without any investment return. This lets us compare it to the actual annuity payments available today. You can also see how much extra money Bob will get as a result of having an annuity.
|Age||Years to live||£ 100,000 / life expectancy||Gross annual annuity||Extra return per year||Implied investment return1|
1 This is the implied rate of return, after charges, used in the annuity calculation.
From this, we can see that annuities do pay back your money over the course of your life (assuming you live as long as expected). However, the additional return is very low (the equivalent of a very low rate of interest).
Why is the return so low? The simple answer is that the insurance companies which provide annuities invest their money in fixed interest investments such as gilts and corporate bonds (sometimes property). The benchmark for annuity pricing is long-dated gilts – I generally use the 15-year gilt yield published daily in the Financial Times.
Here’s a run-down of the income from annuities over the last 5 years, alongside the benchmark gilt yield:
|Gross annual annuity||15-year gilt yield|
It’s clear how the two figures are dropping hand-in-hand. This means that someone who purchased an annuity only 12 months ago would have received £854 more than today – a massive 15 per cent more.
In October 2016, annuity rates fell to their lowest recorded level. So it is indeed the worst time in living memory to purchase an annuity.
There are, however, ways that you might obtain a better annuity rate. Let’s suppose that Bob at age 60 is a smoker and overweight. Because of his poorer health and lifestyle, he is eligible for a higher annuity income (based on the gloomy premise that he will die younger). Anyone with a reason for a lower life expectancy should be able to get an enhanced annuity, so always ask about this if you think you may qualify due to a health condition or medical history.
Be aware that your annuity provider may not offer you an enhanced annuity unprompted. The FCA has censured some insurance companies for not taking their customer’s health into consideration when arranging annuities.
Restoring the reputation of annuities
Bear in mind that the problem lies not with the concept of annuities themselves, but with the low interest rates that make them currently poor value. In spite of this, annuities remain the only product that can pay a guaranteed income for life.
The reputation of annuities has also suffered due to the emergence of other options like pension drawdown. But if interest rates rise and the financial outlook becomes less certain (e.g. due to Brexit) annuities should make a comeback.
The good news is that annuity rates have started to rise again, albeit slowly. Meanwhile, if the UK economy runs into trouble and this affects the stock markets, this might not be good for those who use drawdown. If these trends continue, it may make more sense to lock your long-term retirement income into a guarantee annuity.
It’s therefore possible that those who thought the grass was greener on the drawdown side of the fence may end up being disappointed. The rule of thumb is that when uncertainty strikes, annuities are your friend: because they are dependable even in the most unpredictable world.
Billy Burrows is an independent retirement options expert and industry commentator. Find out more at www.williamburrows.com