The purchase of an annuity is one of the most important financial transactions in the lives of most working people.
Yet it is a subject that tends to confuse — perhaps because people avoid thinking about retirement planning in the same way they try to ignore the idea of getting old.
An annuity is the income a person receives in retirement. The amount of income received from the annuity obviously depends on the size of the pension pot, but other factors include who the annuity is obtained from, and the market rate at the time of retirement. Ideally, a person should convert their pension into an annuity at the right time — when annuity rates are favourable.
Annuities are in the headlines at present, because one of the first acts of the incoming Conservative/Liberal government has been to scrap the obligation to convert a pension pot into an annuity by the age of 75.
There have been good reasons why governments have required elderly people to take out an annuity — it reduces the risk the state may be left to subsidise them through benefits in old age. But it can also make sense for someone to use their pension pot without converting it to an annuity.
A person who is critically ill may want to use it in the short period of time before they die. Alternatively, a pensioner might want to buy investment assets with it to generate a higher income than the annuity would provide.
Annuities are complicated — which is why it is important to take expert professional advice. Sadly, very few people do.
A survey just published by Prudential found that a mere 19% of people planning to retire this year intend to take financial advice on converting their pension into an annuity. Yet the cost of accepting a poorly performing annuity can be very high.
About 60% of people who retire accept the annuity that is linked to their existing pension plan. This is despite the fact that under the ‘open market option’ they can usually shop around for the best annuity on the market. They may also be able to delay the timing of their retirement to match a point when annuities offer a better rate.
Aviva is about to launch a TV advertising campaign explaining the benefits of going to the market for the best annuity — it claims that this may boost retirement income by 20%. For someone with even a fairly modest pension pot this might provide an extra £1,000 a year — which might add up to £20,000 over the rest of their life.
There are now a wide range of web comparison sites that allow people to evaluate the annuities on offer — rates on offer vary not only according to providers, but also depend on other factors, such as personal life expectancy, and whether the pensioner intends to take an initial cash free lump sum.
But whatever advice is taken, the painful truth is that annuity rates are poor at present. Over the last 18 months, annuity rates have fallen by about 13%.
Traditionally, annuity rates have broadly tracked the rates paid by gilts (government bonds). That link seems to have been broken in recent times, with annuity rates falling even while gilt rates rose.
“There are a number of factors in play at present, all contributing to a decline in annuity rates,” says Tom McPhail, head of pensions research at advisors, Hargreaves Lansdown. “Improving life expectancy continues to force insurers to adjust their pay-out terms, as they have to stretch the income payments over longer periods. They don’t know when, or indeed if, this trend will run out of steam.”
In addition, says McPhail, people with serious health conditions are increasingly opting for individualised annuities on enhanced terms. The effect of this is the end of their ‘subsidy’ of the general annuity pool. Meanwhile, investment risk has risen and returns, generally, have fallen.
It has become a bad time to retire. The real question, though, is whether it will ever again be a good time to retire.