Incomes from annuities have been in the doldrums for the last 10 years and are still at historically low levels, writes pensions expert Billy Burrows of financial adviser Better Retirement.
However, there are signs that rates could finally start to increase in 2018 and their popularity grow once again.
Annuities used to be incredibly popular. After all if you don’t have a final salary pension, they are the only retirement products that guarantee an income for life, with no risk of running out of money.
Retirement decision: Savers have shunned annuities in recent years in favour of staying invested and drawing down an income from their pension pots
They are a type of insurance policy that converts a pension pot into a series of regular payments for the rest of your, and possibly your partner’s, life.
In fact until just four years ago, most people purchased an annuity when they retired and only those with larger pension funds opted for pension drawdown, which gives you freedom to decide how much income to take and where your pension pot is invested.
However, during former Chancellor George Osborne’s 2014 Budget everything changed, when he announced: ‘No one will have to buy an annuity’. At this point pension freedoms were born and for the first time most people could choose whether to take out an annuity or not.
By this time, annuity rates had already been falling for some time, and so when savers were given the option not to buy one, most took it.
Why rates have been so low
When a saver buys an annuity from an insurance company, they hand over their pension pot and the insurance company invests it cautiously to make sure that it can afford to pay the saver regular payments for as long as they live.
Billy Burrows: ‘The fate of annuities may be linked to the outcome of the Brexit negotiations’
The safest investments are considered to be government debt – called gilts – high-grade corporate bonds and property. This is because governments and some companies are most trusted to be able to pay back their debts.
These are the types of investments that the insurance companies choose to buy.
However, the rates that these ‘safe’ types of debt pay out have been very low in recent years.
The trend dates back to the 2007 credit crunch, when the Bank of England started printing money – called quantitative easing – and used it to buy these very same types of investment.
As the Bank bought more, the yields paid dropped because with a higher number of buyers looking to buy the same debt the amount of interest needed to entice them dropped.
So as the yields on these investments go down, annuity rates will go down and vice versa.
Today, a £100,000 joint life annuity for a couple aged 65 and 60 and reducing to two-thirds on the death of the first annuitant would pay a guaranteed level income of £ 4,532 before tax.
Four years ago, in January 2014 the same annuity would have paid £ 785 per annum more at £ 5,317. This is a fall of nearly 15 per cent.
Annuity rates have fallen for three reasons. First of all, as explained above, the income or ‘yield’ companies get from the investments that keep annuities safely funded has fallen.
Secondly, insurance companies have increased their expectations of how long people will live so they have reduced payments in order to stretch the income over a longer period.
Thirdly, there are now only about half a dozen annuity providers offering competitive annuities and the lack of competition has kept annuity rates low.
So, the million-dollar question for the annuity market is ‘will yields start to rise and annuity rates get better’?
It is too early to predict significant increases in yields but there are some signs that the tide may be about to change. For instance, inflation is on the increase and the global economy is steaming ahead better than expected.
This means the Bank of England may increase the bank rate later in the year to prevent the economy overheating and to keep inflation below the 2 per cent target.
The fate of annuities may be linked to the outcome of the Brexit negotiations. If there is a good Brexit outcome and the economy remains steady, long-term interest rates and annuities should nudge upwards. However, if there is a bad Brexit and the UK economy dips into recession it will probably be bad news for annuities.
The table below shows how annuity rates and gilt yields moved in parallel over the last five years and how the low point for annuities and yields was immediately after the 2016 Brexit referendum.
Annuities and gilt yields from January 2013 to January 2018 (Source: williamburrows.co.uk)
In order for annuity rates to return to the higher levels seen in 2014, the yield on the benchmark 15-year gilt will need to increase from its current level of 1.75 per cent to about 3.5 per cent.
It will take some time for these yields to double (if it ever happens) so there is little expectation of significant increases in annuity rates soon but hopefully the trend will be upwards.
How long will your pension fund last?
Better Retirement has a selection of tools to help you work out how to use your pension and how long your pot may last.
Most people who have shunned annuities have opted for pension drawdown instead. This involves keeping pension pots invested, favouring flexibility over the guaranteed income offered by annuities.
Those in drawdown plans will have benefited in recent years from a rising and buoyant stock market.
However, if the UK stock market was to come off the boil and equity prices fell, this might cause some people in drawdown to reassess their attitude to risk and start moving from higher risk drawdown plans into much safer annuities.
Despite low annuity rates, the lack of flexibility, and their poor reputation annuities could start to become more popular if the rates increased at the same time as the returns for drawdown plans start to fall.
William Burrows is retirement director at financial adviser Better Retirement and runs annuity and drawdown website www.williamburrows.co.uk.
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