Annuities may be much less popular after pension freedoms but annuities are still important and annuity rates must be monitored.
Before pension freedoms which started in 2015, over 300,000 people a year converted their pensions into a guaranteed stream of income payments by purchasing annuities but since pension freedoms when people can decide whether to take their pension pot as a cash sum, annuity or drawdown, the sales of annuities have fallen through the floor to about 80,000 annuities per annum according to the Association of British Insurers (ABI).
There are three reasons why annuities should not be sidelined or ignored:
- Annuities are still the only policy that can guarantee to pay a fixed income for life no matter how long the policyholder lives without any investment risk
- They provide the benchmark as to the optimum income that can be taken from a pension fund
- They can be used to de-risk pension income solutions in later retirement
Annuity rates in 2016
I have been collecting information on annuity rates since 1990 and annuity rates fell to their lowest levels ever in 2016. The graph below shows how the income from annuities for those in good health has continually fallen since 1990 and they reached the lowest ever levels in September 2016.
Annuity (left axis) is for age 65, £10,000 purchase, single life, guaranteed 5 years and level payments. The yield (left axis) is 15 year gilts. The FTSE 100 (right axis) is a share index of the 100 most highly capitalised UK companies listed on the London Stock Exchange and shows how a pension fund invested in equities may rise or fall in value over time.
The benchmark annuity, £ 100,000 joint life annuity for ages 65 and 60 with 2/3rds partner’s pension and level payments was paying £ 5,263 per annum gross in December 2013 and despite some up and downs the same annuity was paying just under £ 5,000 per annum 12 months ago, but today the income is just £ 4,367, a 22% fall over 3 years, 12 % over the last year.
At the lowest point in 2016 this annuity was only paying £3,802. Clearly timing of an annuity purchase is critical and someone buying at the lowest point in 2016 would have locked into a £ 1,000 less income compared to the best rate at the beginning of the year.
The reason why annuity rates have fallen is simple. Annuities are priced in relation to the yield on fixed interest investments and these yields have plummeted, especially after the Brexit vote in the summer. For example, the yield on 15 year gilts fell to an all-time low just above 1% in late summer before bouncing back to just below 2% by mid-December.
Annuities are also based on average life expectancy and as people are living longer annuity incomes are adjusted downwards because they are being paid longer. Anybody who smokes, is taking prescription medication or has a medical condition may get a higher annuity if they apply for an enhanced annuity. Companies such as Aviva, Canada Life and Legal & General will pay higher incomes for those in poor health.
Although, interest rates are the main factor for annuity pricing, downward pressure on rates has resulted from a fall in demand, lack of competition and reduction in the number of insurance companies offering open market annuities.
In 2016, Prudential announced it was pulling out of the open market annuity market and Standard Life and LV= are also pulling out of the annuity market.
These leaves Aviva, Canada Life, Hodge Life and L&G competing for good health annuities and they are joined by Just Retirement, Retirement Advantage and Scottish Widows in the enhanced annuity market.
No secondary annuity market
Plans to allow people to sell back their annuities to insurance companies in return for a cash sum have been shelved. Although many experts welcomed the U turn on what was regarded by industry professionals as an ill-conceived idea, many customers are angry that the option to convert their low value annuities in to cash has been taken away.
Annuity rates in 2017
The good news is that annuity rates are bouncing back as yields and it seems likely that the benchmark 15-year gilt will end the year at about 2% compared the lowest point of just over 1% in September.
The maths is complicated, but generally speaking, for every 100 basis points increase in yield (e.g. from 2% to 3%) we can expect annuity rates to increase by about 7%.
Increased inflation is one reason why yields may increase and if yields go above 2.5% this should result in about another 3.5% increase in annuities and at these levels they will be much better value.
If the income from the benchmark annuity, currently about £ 4,400 rises to about £ 5,000, we should see a resurgence in interest because at these levels annuities are a more viable alternative to drawdown.
Value for money
If you are 65 and purchase an annuity for £ 100,000 today you can get just under £ 4,400 per annum for life but how do you know if this is good value?
There is a quick and easy way of working this out. Think of an annuity being like a mortgage in reverse. The insurance company will pay you back your initial capital with interest over the rest of your life. If on average a 65-year-old will live for another 25 years it is like a 25-year-old mortgage in reverse. At current rates this suggest an underlying interest rate of less than 2%.
If you think you can invest your pension pot in drawdown and get more than 2% investment return per annum after charges you may be able to get a higher income over the longer term than from an annuity but you will be taking the risk and complexity of investing your pension pot.
Annuities v Drawdown
The main alternative to an annuity is drawdown. An annuity is a form of insurance because it insures you never outlive your income and run out of money whereas drawdown is an investment option where you take income withdrawals from your pension pot.
There are two important aspects of drawdown; the amount of income you take out and the rate of return on your investments. If you take out too much income and or the value of your investments fall you could run out of money.
It is impossible to predict the future, but if the UK economy is going to go through uncertain times as a result of Brexit, the stock market could suffer and consequently pension funds would fall in value.
2017 – A better year for annuities
2017, could be the year in which annuities become more popular as rates rise and drawdown becomes less popular because of economic uncertainty.
If as predicted, interest rates in the UK start to rise and the prospects of higher inflation results in higher bond yields, this should translate into higher annuity incomes.
If, the annuity alternatives such as drawdown become less attractive because of stock market uncertainty more people may change their preference for income flexibility in favour of guaranteed income.
No matter how 2017 pans out, it is very unlikely that annuities will be battered as much as they were in 2016.