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Our latest editorial

March 2010

The future direction of annuity rates is a staple topic of the financial pages, which is not surprising given the importance to the hundreds of thousands reaching retirement each year and needing to switch on an income stream.

Recent economic events are not making forecasting any easier. The Bank of England may or may not stop giving its economic medicine, inflation has picked up sharply prompting speculation about the future direction of interest rates, while external events such as the Greek debt crisis loom large over financial markets that remain finely balanced between optimism and pessimism.

This kind of uncertainty may help traders who make money from volatility, but it is not welcome by retirees who must decide whether the annuity rates on offer today are near to the bottom of the cycle which is already showing evidence of turning.

There is no doubt that the returns from lifetime annuities today are lower than even just a few years ago – Moneyfacts [note 1] puts the overall fall over the last 15 years at more than 40 per cent. Other data shows last year was one of the worst for annuity rates with an average drop of 8 per cent last year, the biggest fall since 2002 [note 2].

The prospect of falling annuity rates has been a great motivation for retirees to turn their pension pot into an income for life as quickly as possible. Why wait when your hard-earned pension pot is likely to buy less income with each passing day?

In today’s environment, this simple argument is facing some serious questions. While not claiming to be scientific in any way, polls [note 3] suggests there are now mixed feelings about where rates are headed among advisers who are active in the retirement income market with a professional awareness of the issues.
 
So rather than being in some kind of inexorable downward trend, there are significant numbers who believe we are actually at or near some kind of low. A likely reason for this view is the extraordinary events of the last couple of years such as the Government’s use of Quantitative Easing as a macro-economic tool. Some believe that the medicine deployed to bring the economy back to financial health has depressed annuity rates, and as the treatment is withdrawn they will pick up again.
 
The economist Robert Kyprianou, the former chief executive of AXA Framlington, appears to be in this camp judging by a recent article in which he questioned what he called the siren call of those crying ‘lock in now before you regret it’ [note 4]. He believes that long-term gilt yields, the benchmark that underpin annuities and whose returns are closely linked to annuity rates, are set to pick up. Furthermore, he believes his views are shared by a number of heavyweight bond investors, such as Bill Gross of Pimco and Richard Woolnough of M&G. [note 5]

One of his arguments is that the outlook for gilt supply and demand is ‘just plain ugly’ and that investors will be looking for a more generous return if they are to continue lending to a UK government that is having to expand its borrowing. Falling gilt prices and rising yields should help annuity rates higher.

Additionally, the Bank of England has decided to pause its buying of gilts through the £200 billion Quantitative Easing programme which has been a significant prop for gilt prices in recent months. Unless demand for gilts from other investors fills the gap, removing that support is likely to see gilt prices fall. And of course, the Bank will want to sell its gilts back into the market at some point, adding further pressure to increase gilt rates. 

There is a further expectation that interest rates will need to climb from today’s record low levels. Although inflation in 2009 was benign – the RPI measure for the year fell below zero for the first time in more than half a century – there are signs it has picked up in recent months to stand above the inflation target [note 6]. The Bank wants to make sure economic recovery is firmly established before taking any action, but it also needs to be seen to be firm on inflation and raising interest rates should help gilt yields.

The macro-economic picture may be suggesting there could be an improving picture for annuity rates, but not all the news is so positive. At an industry level there are pressures pulling in the other direction, most notably Solvency II, the new rules on capital requirements on European insurers due to come into force in 2012.

Despite headlines suggesting ‘EU rules could cut pensions’, there is a need to take a balanced view. UK insurers are making robust representations to mitigate the impact on their businesses during the consultation phase. Currently longer-term contracts look as though they will become more expensive because of the need for more capital backing but the fall in the income available due to Solvency II could easily be more than offset by the wider macro-economic factors mentioned above.

The new rules could actually be a force for good, not only because they fulfill their central purpose of helping to safeguard customers of insurers from future economic shocks but also acting as a catalyst to drive more innovation in the retirement income market. This is a market that is likely to change dramatically as increasing numbers of people start to make active choices about what is right for their own individual circumstances.

When it comes to the returns that individuals can generate from their pension pots, it is not factors such as interest rate policy or Solvency II that are likely to have the biggest impact on the monthly payment. Instead it is personal factors such as what age they choose to buy the annuity and, perhaps most importantly, how healthy they are. A pick up in gilt yields could edge annuity rates a little higher and Solvency II might edge them lower. But being diagnosed with a life-limiting illness could send the income that can be bought soaring.

One of the huge changes in the retirement market has been a move towards segmentation and a focusing on the retiree’s own personal circumstances. This is leading to ‘winners’ and ‘losers’. Individuals with certain illnesses, poor lifestyles or even who live in certain areas can receive a higher annuity income because the provider doesn’t expect to have to pay out for so long. Most of us believe this is a fairer system, although impaired and enhanced annuity buyers such as smokers still need to balance the prospect of taking a little extra now against missing out on a potential more significant uplift later on.

The ‘losers’ in income terms are those in good health. The fact that they are pooling their money with others who are also less likely to die prematurely means there is very little mortality subsidy to help boost the income. Arguably, someone around 60 today deciding to retire will receive very little extra income from a lifetime annuity than if they invested directly in similar low-risk assets, but they will be giving up all flexibility to react to changing circumstances later.

Increased life expectancy means that the mortality subsidy that a few decades ago used to give retirement incomes a useful fillip is now much smaller for large numbers of retirees in their 50s and early 60s. It hasn’t disappeared altogether but really kicks in later in life.

This needs to be combined with the fact that with greater age, the risks of poor health rise significantly. Official figures show that the average 65-year-old can expect to live disability-free until just after age 75. Those who wait to buy a lifetime annuity are far more likely to qualify for an enhanced rate which, if the illness was particularly severe, could result in an income of up to an extra 75 per cent. There are now numerous ways to buy a secure income at levels similar to a lifetime annuity while still retaining the flexibility to capture more potential gains in the future.

Attitudes towards retirement are changing. People are increasingly choosing or being forced to work later in life, perhaps on a part-time basis. Solutions that allow income flexibility and the ability to rethink options later on are, we believe, set for huge growth in the early retirement market. Advisers will recommend cocktail solutions that combine both certainty and flexibility. Less flexible lifetime annuities will be chosen later in life when the rates are perceived as more generous and the need to safeguard income until death becomes paramount.

The truth is that nobody knows for sure where annuity rates are heading over the next few years. Retirees also do not know what fate awaits them on a personal level. Advisers cannot hope to answer these questions. But what they can do is take a flexible approach – rather than jumping one way or another, the smart advice to clients must be to choose plans that keep their options open to adapt to whatever the future brings.
 
Ends

Notes:

1. http://moneyfacts.co.uk/news/annuities/annuity-rates-at-record-lows/
2. http://www.williamburrows.com/library/CDDec2009.pdf
3. One such example is Living Time’s own poll amongst financial advisers – 43% said annuity rates would increase , 30% said stay about the same and 27% said they would fall (n=120)
4. http://www.citywire.co.uk/personal/-/comment/retirement/content.aspx?ID=379628
5. http://www.citywire.co.uk/personal/-/comment/other/content.aspx?ID=380839
6. http://www.statistics.gov.uk/downloads/theme_economy/Rp04.pdf