What’s next for annuities?

What’s next for annuities?

In the last week of June, annuity rates from all the top providers fell by between 2 per cent and 3 per cent, a result of the dramatic drop in bond yields following the unexpected referendum result. Translated into real money, somebody with a £100,000 in a pension pot will get about £150 a year less for the rest of their life if they purchase an annuity in July compared with June.

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.