Financial Times, December 22, 2001
Debbie Harrison explains why you shouldn’t compare annuities to pure investments such as equities
The conventional annuity is one of the most widely misunderstood financial products in the retirement market. It is also more complicated and flexible than many investors appreciate.
Most important of all, it is the only available product that provides a guaranteed income for life, irrespective of investment returns and no matter how long you live. Mike Wadsworth, a partner at the Watson Wyatt pensions consultancy, says: “Many people in retirement will find it difficult to generate an adequate income without making use of the annuity structure for some or all of their assets. The whole point of annuities is to squeeze extra income out of assets over your lifetime, however long you may live.”
But many people suspect that annuities offer poor value for money. In recent years the income from annuities, based on bond yields, has fallen.
But this has not happened in a vacuum. Over the long term there has tended to be an inverse correlation between equity returns and the yields on gilts. In theory, therefore, your fund size should rise to compensate for the drop in the amount of income an annuity will secure for each £1,000 of your capital.
But it may not be quite that simple: investor behaviour can upset the neat mathematics. Bond yields will fall if demand rises significantly and pushes up bond prices. Demand for bonds will rise when investors switch to this asset class as a safe haven.
Maturing occupational pension funds also weight their asset allocation more heavily towards bonds to pay the guaranteed pensions. The combined impact of these two developments could change the long-term relationship between equity returns and bond yields. Bond yields and equity returns might even decline together.
Annuities are so complicated because they combine investment with insurance and it is the insurance element that provides the rock-solid guarantee of the lifetime income. This means you cannot compare what you get from an annuity with the return from, say, an equity or gilt fund because the pure investment route offers no lifetime guarantee.
When you consider annuities, you need to assess how these two ingredients will interact. To calculate its “rate”, the insurance company assumes it will return your capital, with interest, over the number of years it expects you to live.
On top of this it adds a rate of interest. This is broadly equal to half the yield on bonds at the time of purchase. The reason it is only half is that your capital in effect runs down over the payment period.
In addition, there is a cross subsidy from the pool of lives within the annuity fund. Those who die early in effect subsidise those who live longer than average number of years “break even”.
Women live longer than men on average, so the income they can secure will generally be less than that for a man of the same age. Those in poor health may be able to secure a higher-than-average income if their life expectancy is reduced.
Even if you want to conventional annuity with no frills, those with a personal pension or similar plan – for example, a retirement annuity or stakeholder scheme – are under no obligation to buy from the original pension company.
The “open-market option” allows you to take the proceeds of your pension fund away form the plan provider and buy your annuity from a more competitive company. Do seek expert independent advice if you intend to do this.
The top names in personal pensions are quite different from those in annuities and rates often change. The difference between the best and worst annuity rates at any time can be as much as 25 per cent and even among the top-10 companies there could be as much as a 10 per cent difference.
Your adviser will also weigh up any penalties or loyalty bonuses that affect your pension fund if you move it away from your original company. These may negate better terms available elsewhere.
The situation is different for members of occupational money-purchase schemes. Here the trustees usually buy the annuity on your behalf and pay the income to you. Check that the trustees shop around for the best rates using an annuity specialist or their independent consultant. The scheme should be able to negotiate the best rate for you.
In most cases, it would only add to the costs if you transferred out and bought direct from an insurance company.
Those who use their pension scheme or plan to opt out of the state earnings-related pension must use the fund built up from the rebates of National Insurance in a specific way. The rules vary depending on when you were contracted out, but generally these funds must buy a spouse’s pension and must increase each year – usually at 3 per cent.
When you look at annuity rates the benchmark figures relate to the level annuity – that is, an income that remains static throughout the payment period and is payable to a single male. There are several useful features sold as optional extras in addition to the basic annuity.
You may consider some of these options essential, but your choice will depend on your personal circumstances and financial goals in retirement. Any options you choose will reduce the annuity rate. Once you hand over your money you cannot change your mind about the choice of insurance company or the special features selected.
Those who are concerned about passing on their wealth cannot leave a lump sum for a dependent but can secure a lifetime income. An alternative for those who purchase their annuity later in retirement is to buy a 10-year guarantee so that the income continues for up to a decade if they die soon after buying the annuity.
Most annuities are guaranteed for five years, which means that if you die after two years the remaining payments over the following three years are paid to your estate. The maximum guarantee is for 10 years. The reduction in initial income for the five-year guarantee is 1 per cent at age 60 rising to 5 per cent at age 75. If you buy a joint life annuity that pays your spouse, partner or other dependent person a pension if you die, the reduction in initial income for a 50 per cent dependent’s pension is 12 per cent (assuming a male annuitant aged 60 with a spouse of 57).
With an escalating annuity, the income rises in line with full retail price inflation or at a fixed rate each year - for example, 3 per cent. The reduction in initial income for a 3 per cent annual increase or link to retail prices is 30 per cent at age 60.
Annuity rates are based on average life expectancy, so if you are in poor health you will be at a disadvantage. Fortunately, several companies, including Britannic, GE Life, Prudential, PAFS, Sun Life and Scottish Widows, offer “impaired life” annuities, which pay a higher than average income because they assume you will have a lower-than-average life expectancy.
This is particularly good news for those with a very serious condition who need the maximum income possible to allow them to enjoy a better quality of life for their remaining years. But even those with a less serious condition might be able to increase their income by a significant amount if they are individually underwritten.
To qualify you would have to complete a detailed questionnaire and in some cases the insurance company will require a medical report from your doctor. The options available under a standard annuity are also available but where you want to provide a pension for your spouse, for example, his or life expectancy will affect the rate you secure, so it may be better to use another source of capital for this purpose, if you have one.