The government first announced plans for a tradeable market in annuities last year (2015) as part of the ‘freedom and choice’ reforms. The premise was sound – that pensioners who had missed out on the reforms and had already bought an annuity would have a second chance to access their pension savings cash upfront.
Sceptical
Market participants were the chief sceptics, doubting that such a thing were possible in practice, questioning whether the necessary infrastructure existed or whether insurance companies would be prepared to facilitate such a transformational manoeuvre. But in December we discovered that the government had every intention of making good on its promises, announcing that trading in an annuity would require advice and that private sector bureaus would be allowed to act as brokers, with insurers likely to be allowed to buy back their own annuities.
Plenty of details remain to be worked out, but assuming they can be worked through, under what circumstances would selling back an annuity be the right decision for the consumer, and what could lead to a positive recommendation to do so?
Consider the example of a 65-year-old man who had bought a two-thirds joint life annuity in February 2015, just before the new rules kicked in. It just so happens that this was one of the worst months ever for buying an annuity, and, according to figures from William Burrows Annuities & Retirement, he would have received an income of about 4.6 per cent, or £4,600 a year for £100,000. Four years earlier his £100,000 would have bought an annual income of roughly £5,800 – and last month it would have bought £4,900. So how much is his annuity worth today, and how much would it be worth if prevailing rates were back at February 2011 levels?
For this slightly back-of-a-cigarette packet estimate, it makes sense to price annuities as if they were perpetuities, which is a type of bond traded in the market with no redemption payment and no fixed end date to interest payments. Of course, in practice annuity actuaries would take into account the life expectancy of the annuitant as the most likely end date of the payments.
An annuity that was yielding 4.6 per cent when it was bought would be worth £93,700 with prevailing annuity yields at 4.9 per cent and £79,200 with yields of 5.8 per cent. If annuity rates improve – because the underlying gilt yields which drive prices have improved – then the value of your annuity will fall. Just because current annuity rates offer better value will not be a good reason to trade in your annuity – any more than selling a bond priced when rates were lower in order to buy a bond today when rates are higher would ever make sense.
Trading your annuity the other way around might make sense though. If you had bought an annuity for £100,000 in February 2011, it would have been worth about £119,000 in December 2015, using the same perpetual formula; in short you would have made a 19 per cent profit even after taking the income in the meantime.
Along with the many other heroic assumptions made in this calculation we also assume that there is no cost to the trade – which of course there would be. But in this case the spread on the trade would have to be in double digits before it stopped making sense.
The other reason why this trade may have some logic is that if yields have fallen – which would make the price of your old annuity higher – there is a good chance that stock markets have fallen too. Even in this crazy world of quantitative easing and central banking control, when markets are in ‘risk off’ disaster mode, gilt yields still fall and so do stock market prices.
Selling your annuity when its price is high in order to invest in a stock market drawdown portfolio when equity market prices are suppressed makes sense.
Change of circumstances
One of the main triggers for clients wanting to trade in an annuity will be a change in personal circumstances. One example could by the desire to switch from a joint life to a single basis due to the death of a spouse. With all else being equal a joint life annuity generally costs 8-10 per cent more than a single life annuity.
Changes in health conditions are likely to cause many enquiries to advisers, with some insurers promising up to 40 per cent increase in income for normal ill health problems (such as smoking related conditions) and up to 90 per cent increase for those with very serious conditions.
The difficulty with this trade is how the existing annuity is priced. Yes, if the client were to buy a new annuity today they would get a better deal, possibly a much better deal, than their existing annuity offers. But if a client has a life expectancy of five years, then the value of their existing annuity will be drastically reduced.
If a client had bought a £5,800 annuity in February 2011 for £100,000, what would that £5,800 a year be worth now if it is expected to end in five years’ time? For this equation we value the income as a five-year bond with no final redemption payment based on prevailing yields (so 4.9 per cent in December 2015.) The answer is just £25,400.
This may still make sense to the client, who would rather have their last five years of income upfront. But if he does recover to live longer than the doctors predict (which, anecdotally if not statistically, seems to happen all the time) he will run out of money, and is likely to fall back on state benefits.
Still, having the power to make such a decision – even if it is ‘insistent’, that is against the recommendation of his adviser – is in line with the underlying ‘freedom and choice’ philosophy that has driven the relaxation of restrictions around income in retirement thus far.
Some clients may be able to get what looks like a good deal on trading in their annuity. If they had bought it when yields were much higher than they are today, the temptation may well be to trade it in and invest through drawdown instead.
The obvious advantages of drawdown over annuities – namely that control over capital is maintained and that any remaining pot can be inherited – are likely to be compelling. And the bottom line is that whatever the financial strengths and weaknesses of the argument, regaining control of significant capital sums is likely to prove the main incentive.
Barriers
Transaction costs could be the main barrier but there are reasons to believe that trading in a second-hand annuity – whether back to the original provider or a third-party – may be competitively priced. Assuming the income remains linked to the life of the original party but paid to a second party, there are a number of institutions for whom this would be an attractive purchase. The main benefit is that the value of the annuity grows if the life expectancy of the individual grows, which makes it an unusual asset.
By hedging out the interest rate risk (if prevailing rates rise the value of the asset will fall) the buyer can gain exposure to a life expectancy-linked asset – which is of course one of the main risks the UK’s vast pools of defined benefit pension schemes are exposed to.
At scale, where a pool of second-hand annuities can be proxied to average life expectancy, this could have many applications in the market – all of which can only help improve efficiency in pricing which would be good for the consumer.
Bob Campion is head of institutional business at Charles Stanley Pan Asset Capital Management