Annuity rates to fall as much as 20%

by Bob Bullivant on 09 December 2011  |  6 comments
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Annuity rates continue to fall, and may fall another 20% yet. So how can you limit the damage?

People at retirement are being hit both by falling annuity rates and reductions in the maximum amount that can be taken from drawdown. The questions on everyone’s lips are "Will annuity rates go up any time soon? And if so, when?"

My personal view is that you should not hold your breath. Here's why - there are really only three aspects to an annuity rate:

- how long you will live;

- the investment return on a bond portfolio  (used by investment professionals); and

- charges associated with the annuity.

Let me deal in detail with the first two as charges will not vary that much between providers.

We are all living longer

As we know, people are living longer, so the pension fund therefore has to last longer and that ultimately has a downward impact on rates. Couple this with the rapid growth in the enhanced/impaired market, which means less ‘cross subsidy’ from those who die sooner and you start to see that we should not hold out too much hope for any improvement in the mortality assumptions used by the actuaries, who are the men in white coats who work out how long we will all live.

There is a counter long term argument that runs that life expectancy will fall as a generation brought up on a diet of junk food and no exercise grow older! That may be some while away though.

No sign of a rise in interest rates

Interest rates must go up eventually, and that will in turn increase annuity rates. But when?. The economy is going through a difficult time and low interest rates have traditionally been the classic stimulus. In the foreseeable future – by which I mean a year out – do you really see a rise in rates?

No is probably the answer.

The Government seems committed to more quantative easing which means the Bank of England will buy bonds depressing their price further. Rates have fallen rapidly over the last few months since the last round. More QE will almost certainly lead to more falls.

The influence of the EU

There is also a European influence. From December 2012 all rates will have to be unisex. This will result in a fall of an estimated 6% in male rates and  a rise in female rates, although it is debateable as to how much the rise will be. And then in 2013 a European instrument called Solvency 2 hits us.

As I have said, annuities are currently calculated using the yield from a portfolio of bonds - including ‘corporate’ bonds (which are effectively IOUs from big companies) because they pay a higher yield which can be passed on in the annuity rate.

However the price of the extra yield is that the company issuing the bond could default. The actuaries cover for this risk by creating a reserve fund using a small proportion of the interest payment. The result is that in the UK – to the best of my knowledge - no company has ever defaulted on an annuity payment. We do have a very prudent actuarial profession.

From 2013 the EU will insist that when calculating future annuity liabilities, the rate of return on government bonds is used. As a result annuity rates will be based on gilts rather than corporate bonds and of course gilts pay lower interest rates.

The expected impact is a reduction in annuity rates of between 10 and 20%.

What can you do?

So, with all of that bad news, the big question now is what can you do? The obvious thing is to defer taking the annuity, but be careful about where your funds are invested. The markets are very volatile and you could end up with a lower fund and a lower annuity rate – a double whammy if ever I saw one! It is possible to part cash funds and buy annuities over a number of years to average the rate. If you do this you could use tax-free cash each year as income. This is known as phased purchase.

Income drawdown is an option, but again you are at the mercy of the markets. A simple test is to ask yourself if you can afford to reduce your income to zero in the event of market falls. If the answer is no then drawdown is probably not right for you. Do also bear in mind that since April the maximum you can withdraw is broadly the same as you can get from an annuity – the formula uses bond yields.

There is no easy answer other than proceed with care and understand why you are taking a course of action – and of course do shop around. lovemoney.com has an excellent annuity tool on this site which gives you a good starting point.

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