What’s next for annuities?

One year ago, on 1 July 2015, the yield on 15-year gilts was 2.56 per cent, but recently they fell to 1.58 per cent. In pension jargon, for every 100 basis points fall in yields (for example, from 2.5 per cent to 1.5 per cent), annuity income is expected to fall by about 10 per cent. This is exactly what has happened. A year ago the income from the benchmark annuity (£100,000 annuity for two people aged 65 and 60 with two thirds of partner’s pension and level payments) paid nearly £5,000 a year gross. Today, the income has fallen to £ 4,417 a year – a fall of nearly £600 a year, or 11 per cent.

The reasons for these significant cuts is simple. Annuity rates are priced in relation to yields on gilts and corporate bonds. This means that when yields fall, annuity rates also fall. One of the reasons why yields have fallen is that in times of financial uncertainty investors buy gilts, and this causes yields to fall. It is really only simple supply and demand; the higher the demand the more the price goes up. The more astute will know that annuity providers actually invest their annuity funds in other fixed-interest investments, including corporate bonds, but gilt yields are still a good benchmark for pricing.@Image-2ef0b02c-d963-4677-9a62-c2855d82f7f8@

I first starting writing about annuities in about 1990, and I remember the headlines in the national press when rates started to fall in 1995. The headlines included such colourful language as ‘legalised theft’ and ‘insurance companies are screwing their clients’. My favourite quote was, and still is, ‘my dog could have done better’.

Looking at back at that time, when the yield on 15-year gilts was about 6 per cent and the benchmark annuity was about 10 per cent, I wonder what all the fuss was about. A lot of people would like these rates today.

Then it was my friend Ian Cowie, then at the Daily Telegraph who coined the phrase ‘double whammy effect’. He was referring to the time after 2001 when both annuity rates and equity prices were falling, so it was bad news for annuities and bad news for drawdown.

Here we are today with 15-year gilts yielding 1.56 per cent and annuity rates at rock bottom. Rates have never been so low, and arguably, the financial outlook has never been so uncertain.

As I get older I keep saying ‘the answers depend on the question asked’. So what are the questions advisers, their clients and policymakers asking. My best guess is the following:

What is the short and long-term outlook for annuities?

The short answer is it depends on bond yields. The long answer is it depends on bond yields. Next question please.

Events are moving very quickly, and it is very difficult to form a view about the future. My own views are changing as I listen to the Governor of the Bank of England talk about a possible reduction in the bank rate over the summer. In the past there have been other factors influencing annuity pricing such as Solvency II, increased life expectancy and the impact of pension freedoms. Perhaps we have got to a position where these factors have less influence and the underlying bond yields have more influence.

Is this the final nail in the coffin for annuities?

I can answer this with a very clear and definite “no”. There is no escaping that a competent adviser or rational investor would question the wisdom of purchasing an annuity at these low levels, but once yields bounce back (if they do) annuities will come back into play.

The problem with annuities is not the concept of annuities, but the underlying interest rates. If we go back to basics, the reason why annuities are so important can be explained by looking at what would happen if there were no annuities. Investors would be faced with two issues; how much income to take and where to invest. Take too much income and they will run of out of cash later in life, take too little income and they will not have received the full benefit of their pension savings. Invest in risky assets and they will be taking undue risk, but to invest too cautiously they will be locked into poor returns.

An annuity solves these problems and provides the ‘optimum distribution of income’, as the academics say. One of the issues US academics have grappled with is the so-called ‘annuity puzzle’. If annuities are so good for people, why do investors shun them? The answer lies with a number of behavioural factors, such as the need for flexibility and the desire to leave a legacy.

In my view, there is a good future for annuities and I suggest two reasons. First, an annuity is the only policy that can pay a guaranteed incom /pension for the rest of the policyholder’s life with peace of mind and security. Secondly, annuities are a very useful retirement planning tool.

What are the key retirement planning issues for advisers and their clients?

Since pension freedoms, the new buzz word in retirement planning is flexibility, or to put it another way, “retirement is not an event but a journey”. I describe it as a transition from a position in their early 60s when people understandably favour flexibility and control, to the recognition that by the time they reach their 70s, peace of mind and security take higher priority. Annuities have an important role to play here because they can be used to de-risk a drawdown plan over time.

My own view is well known. Retirement does not have to be black or white, and many more people could benefit from a combination of annuities and drawdown. The new hybrid plans and blended solutions make this approach easier.

Finally, advisers (and those annuities without advice) must take some of the technical issues into account, not least when is the best time to purchase an annuity. In simple terms, the benefit from the mortality cross-subsidy is now very small at younger retirement ages but increases with age. This suggests that the optimum time to purchase an annuity is nearer the age of 70 than 60.

In conclusion, low interest rates are clearly not good for annuities, but this does not mean annuities do not have an important role to play in retirement income planning. Jane Austen is still right when she wrote: “An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it”.

Billy Burrows is director of Retirement Intelligence