Annuities: Shopping around is about more than price

For as long as we have had personal pensions, annuities have been the bedrock of pensions in payment but now that annuity rates are at an all-time low it is time to re-evaluate the role of annuities in paying pensions and to suggest that those with above average pension pots consider some of the new flexible annuity options.

Before discussing the alternatives it will be helpful to recap why annuity rates are so low. Rates have been falling almost continuously since 1990, the year in which I first started keeping records of them. In 1990, the annuity rate for a 65-year-old man was more than 15.5 per cent; today it is less than 6.5 per cent, a fall in excess of 50 per cent. Back then the yield on 15-year gilts was greater than 11 per cent; today it is about 3 per cent. And inflation in 1990 was 10 per cent plus, whereas today it is around 5 per cent.

During August 2011 annuity rates hit their lowest levels since 1990 and matters were made worse because of the so-called double whammy of falling annuity rates and falling equity prices.

In August, annuity income fell by more than £300 a year, or 5 per cent, making this the largest monthly fall on record. During the same period the UK stock market fell by 9 per cent.

The main reason for the sudden reduction in yields is the flight to quality resulting from the European and US debt problems. At times when investors are worried about global equities there is a strong demand for gilts. As the price of gilts rise, the yields fall. UK gilt yields are at their lowest level for many years.

Unfortunately there seems little sign of an end to the current period of volatility as bond yields and equity prices continue to be volatile. I would like to predict a rise in annuity rates but as I fear more storms could be on the horizon this could be wishful thinking.

One of the issues with the current way in which investors convert pension pots into income is that annuities have been commoditised. Investors are being told to shop around for the best annuity which they are doing with much enthusiasm but the problem is that most shoppers only know how to shop on price; few know how to differentiate on quality.

But what is quality when it comes to annuities, surely buying an annuity is all about getting the highest income?

To answer this question we need to consider two things. First all clients are not all the same and second most people can expect their annuities to be in payment for 20 or even 30 years.

I am like a record. There are three types of customers. Those with a small pension fund who probably should invest in a guaranteed annuity, those with middle-sized pension funds who should consider hedging their risks and those with large funds who may have other priorities other than maximising income.

There are only two reasons why those with small pension pots should have other types of annuities. One is to offset the future effects of inflation and the second is to have the flexibility to benefit from higher annuities in the future for instance if their health deteriorates or interest rates rise. As the state pension which accounts for most of their pension income is inflation-linked and as they cannot afford to take risk with their pension, guaranteed annuities are the preferred choice for these investors.