A safe bet

And this year Mr Osborne announced plans to allow people who had already bought annuities to sell them. This latter proposal may be unworkable, but the average member of the public will have got the message loud and clear: no-one will have to buy these awful things ever again, and those unlucky enough to have one will be able to dispose of them.

Annuity sales, 2013 to 2015

*The ABI did not quote values for Q1 2015, but insurers have said that average values are higher with people taking smaller amounts as cash.

Over the past two years all the leading annuity providers have had to cut jobs and in some cases have widened their offering to include other retirement income products, most notably equity release. Two of the larger specialist firms, Just Retirement and Partnership, have announced that they are to merge.

For those with small funds I have long argued that making them buy tiny annuities does not make sense, but I feel that Mr Osborne is guilty of throwing out the baby with the bath water. Customer surveys consistently show that people want guaranteed income for life, that they do not want their income to expire before they do. The press and politicians may have vilified the product with the name ‘annuity’, but they cannot change the fact that what most people want is an annuity.

Annuities provide a guaranteed income for life. For the likes of Henry Allingham who received payments for 53 years up to his death in 2009 aged 113, this was a great deal. For others who do not live so long, annuities still provide insurance against living too long, with a guaranteed income and with the options to add annual increases to combat inflation and dependants’ pensions too. And one of the good things to come out of the Pension Freedoms was the ability for insurers to add guaranteed payment periods longer than the maximum 10 years set out in Finance Act 1970. (Yes it really did take 45 years for the legislation to catch up with improving mortality)

One of the concerns raised by many people on reaching retirement in the past with money purchase funds was “if I die they will keep all of my money”, but with guarantees available for as much as 30 years this simply is not the case any more.

The table below shows current rates (obtained from the MAS website) for different guarantees, as well as the amount of capital each guarantees to return.

*Rates are for a 65 year old buying a level annuity.

I wonder how many of the people who have shunned annuities since March 2014 know that they can take income with a guarantee to get at least one and a half times their original investment back, even if they die on day 1?

A number of “guaranteed drawdown” products have been launched since March 2014 to add to those which already existed. These generally aim to provide the key advantages of drawdown with the best elements of annuities to give clients the best of both worlds, but do they achieve this?

Our analysis suggests that generally they do not. Someone starting out in drawdown needs to have a high percentage of their fund invested in equities, so that they can achieve the critical yield required to match the annuity income available. But guarantees cost money, and cannot be provided without imposing investment restrictions. Typical guaranteed drawdown plans limit equity exposure to 60 per cent of the pension fund, and include guarantee charges as high as 1.5 per cent a year – and this is on top of the fund management charges and any adviser charging.

If clients have sufficient funds and they want some guarantees, then the simple solution is to secure their ‘must have’ income in an annuity with the other part of their fund in drawdown with a high equity content, looking to achieve higher total income but built on the bedrock of an annuity. Of course annuities include a cost for their guarantees, but they do not have to cover ongoing investment management and adviser charges.

It is easy to see the advantage to an adviser, and guarantees are certainly easy to sell – particularly if you do not use that dreaded word ‘annuity’ – but it is difficult to see what the client gains, beyond an expectation of higher income and the likelihood of being disappointed in the future.

As people live longer the key question should not be “Why buy an Annuity?”; it should be: “When to buy an Annuity?” Mortality subsidy for anyone lucky enough to be able to retire at 60 is worth less than 0.5 per cent a year, but by age 80 it will reach about 4 per cent a year. To put that another way, you will have to achieve returns on drawdown funds more than 4 per cent a year above the gilt yield underlying an annuity to end up with more income from age 80.

If the gilt yield is 2 per cent a year and the reduction in yield to cover expenses is 1 per cent a year, someone of 80 will need to achieve 7 per cent a year plus to break even. With current low levels of inflation this means the target return just to break even is 7 per cent above inflation. You might sell such a high ‘critical yield’ to someone in their 20s or 30s, but I rather fancy the 80 year old will be less prepared to gamble. And that, of course, assumes that they are competent to make that decision and will not leave it to their Power of Attorney.

The pension freedoms will do away with the need for people to buy small annuities which cost insurers too much to administer. They will also highlight to people that there is more than one option when they reach the policy maturity date. But annuities will remain viable as a financial product. This is because once all the hype about lamborghinis and pension bank accounts has died down, annuities will still be able to do what no other product can do: they will provide guaranteed income throughout the annuitant’s lifetime and, if long guarantees are included, they will do so after the annuitant has died.

David Trenner is technical director of Intelligent Pensions

Key points

Annuities have been badly hit by George Osborne’s political antics.

For those with small funds, making them buy tiny annuities does not make sense.

If clients have sufficient funds and they want some guarantees, then the simple solution is to secure their ‘must have’ income in an annuity.