So, where are we at with annuities?
Mark Swann, director of Simply Retirement gives his thoughts on where the annuity market currently stands, and indeed where we are headed in terms of retirement and annuities.
Annuities still seem to be the default option for many people taking their retirement benefits with 95% still buying an annuity . I use the term ‘taking retirement benefits’ because buying an annuity doesn’t necessarily mean that people are retiring. Many are still working and perhaps they want the extra income to help them get by; or maybe they are scared by the prospect of falling annuity rates and feel that it’s better to commit to an annuity before rates drop further. My experience suggests that the days of people retiring on their 65th birthday and getting their pension income the following day are changing. It would seem that many more people ‘phase’ their retirement by working longer, possibly part time, and can afford to delay the payment of their pension. Alternatively, perhaps they can’t afford to stop work and live off their pension alone. The Equality Act 2010 allowing people the right to work on after 65 may have had an impact.
In 2010 the average pension fund used to buy an annuity was £25,874 . Interestingly, this figure has dropped since 2005 and 2006. If this was your only pension your income today would provide £1,431 per annum. The state pension is £5,587.40. Could you live on this alone?
Maybe this change in lifestyle and retirement habits will call for greater choice and flexibility in the design of pension income contracts in the future? Currently we have a few options with Pension Drawdown accounting for 5% of the retirement solutions in 2011 .
We are certainly seeing an increased awareness in people taking retirement benefits; not only of their ability to shop around (known as the open market option) but also that they should exploit any lifestyle or health issues they have to obtain a higher income. From April 2013 the option to shop around instead of staying with your current pension provider must be given greater importance when your pension company outlines your choices for arranging your retirement income . This improvement in consumer choice is demonstrated in the following figures. In 2008 there were over 300,000 internal annuities arranged and just over 150,000 bought through an external provider. In 2012 this gap has decreased with internal annuities accounting for a little over 200,000 of cases and external annuity purchase increasing to nearly 200,000 . It was shown that in 2007 almost two-thirds of annuitants bought their annuity ‘internally’ or with their existing company . Additionally, the growth in the enhanced annuity market has seen it more than double since 2006. The number of people who now qualifying for an ‘enhanced annuity’ is estimated to be 40% compared with sales in 2004 of 10% across the market.
In 2011 the total enhanced annuity contracts sold accounted for 19% of cases across the whole market (internal and external). When people bought an annuity externally, the proportion of people who received an enhanced annuity rate was 40%, compared with 2% of enhanced rates being arranged internally. On the face of it this is a strong and compelling reason why you should shop around and research the whole market, taking the time to research any health issues. If I wanted to look pessimistically at this data I could argue that everyone had actually ‘shopped around’ and then a very large proportion had discovered they were in fact getting the best rate from their current provider. However, I just don’t believe this is the case. The reason for this is that the Prudential are one of the largest annuity providers in the market place because they have a very large number of existing pension policy holders. I can reasonably say, with some confidence, that I have not seen the Prudential offer the best annuity rates, when I have researched the whole market in the last year, for 99% of my clients. Therefore, they must ‘win’ this business based on the laziness or lack of understanding that consumers have about arranging their annuity. When we think about this in a little more depth, it just wouldn’t be a strong business argument for Prudential to offer the very best rates when they get so much profitable business on this basis.
I always feel it is important to remember back to why we have and use annuities. Before legislation in 1995 it was the only and the compulsory option. In those days annuity rates were 15.2% in Jan 1991 and 11.54% in April 1995 compared to 5.58% now (August 2012) .
Annuities as insurance policies
However, an annuity contract was seen as an insurance policy. You were buying an insurance plan that guaranteed you would never run out of savings and your income would be paid for the rest of your life. This is still true, but we tend to look at an annuity now as an investment contract and focus on the return or yield being offered on the capital. Many customers focus on either the comparable return offered by a bank (but they don’t lose their capital) or they work out how long they need to live to get their fund back. In reality, it’s a combination of the two. However, you can see why the assurances and guarantees make annuities a favourite with the government and the regulators. The value of an annuity is further supported by a study which showed how men underestimate their longevity by four-and-a-half years and women by six years . A male age 65 in 2010 is expected to live until 86.1 years and a female until 88.5 years .
What I have noticed is that for many years now there has been a prediction about how the annuity / retirement market would grow exponentially because of the baby boomers reaching 65 from 2011. It is also argued that this sector of the population have the greatest wealth because they have received the benefit of state benefits and the welfare state, final salary schemes and increases in house prices. I have certainly not seen this trend of more people with greater funds buying annuities since 2011. In fact, annuity sales have fallen since 2008 until 2011, although we are expecting a big increase in 2012 because of the EU legislation causing rates to drop at the end of the year. I can only put my own interpretation on this trend and would suggest the reduction demonstrates reluctance in ‘pensioners’ wanting to buy an annuity in the uncertainty and wake of the 2008 Financial Credit Crisis. This uncertainty has led to inertia. I feel it necessary to comment on what a mistake I believe this tactic to be. Annuity rates have fallen further, funds have not increased and whilst these people have been delaying their annuity purchase they are now faced with a smaller future income and have lost years of payments.
To demonstrate this, in Sept 2007 the FTSE 100 index was 6,303. As a crude comparison to a pension funds’ performance, let’s suggest this was the investment. The FTSE 100 dropped to 5,635 in August 2012. At the same time an annuity rate for a male age 65 has also dropped from 7.36% to 5.58%.
To make the maths relevant we will use a fund value of £50,000 and assume it had not fallen between 2007 and 2012. In 2007 they would have received £3,680 per annum. Now they will get £3,105 as a 70 year old (5 years older) . Not only are they £575 worse off each year for the rest of their life. They did not get 5 years’ worth of payments since their 65th birthday, totalling £18,400. If they live until age 86 (as expected) overall they are worse off to the tune of £30,475.
I would suggest that this situation could well get worse with the introduction of anticipated EU legislation such as the Gender Directive and Solvency 2. I haven’t heard anyone arguing that they expect annuity rates to improve in the future. So, I think my message is, if you want an annuity, get on with it. Having said that, surely the rock bottom annuity rate is arrived at by paying your capital back over your expected life time, with no investment return? We are far away from this but importantly, how likely is it that rates will get better and when?
Where I feel that some attention should be given is the impact of inflation to your income. The typical annuity pot would buy a male aged 65 £1,431 per annum today and this would not increase. If inflation is runs at 3% per annum, the actual purchasing power of the income in 15 years will only be £918. The value of the income has been reduced by one-third. I feel that this is where there is a need for education and guidance when consumers buy an annuity. The problem we face is that inflation-linked annuities are expensive and would only provide a starting income of £903 today . This is how a combination of products could best meet an individual’s needs and an Asset Backed Annuity, where the income is linked to the performance of an asset / fund, may provide a solution, or should at least be considered.
In short, there doesn’t seem to be a perfect solution for retirement income but I am certain that annuities will continue to play a significant, valuable and important part of the solution in the future.
1. Deccumulation transactions in 2011 – source ABI
2. ABI stats (case count)
3. ABI stats (case count)
4. Guidelines by ABI to improvements to ‘wake up’ packs as you reach retirement with greater emphasis on the option to shop around.
5. ABI stats (case count)
6. ABI Research Paper No8 2008
7. £10,000 purchase price for a male age 65 based on his lifetime only with no increases in payment and a 5 year guarantee period.
8. L&G, Risk of miscalculating longevity Dec 2009 by Joseph Lu.
9. Office of National Stats.
10. Current annuity quotes – 20 Sept 12, Avelo / Exchange – Single Life, level with a 5 year guarantee period.
11. Current annuity quotes – 20 Sept 12, Avelo / Exchange – Male 65 – Single Life, increasing with RPI and a 5 year guarantee period.