Are government plans to let pensioners sell annuities workable?

The pensions minister wants to let current pensioners cash in their pensions, but experts are warning of pitfalls.

There has been a lot of coverage of a new government proposal for pensioners who already have an annuity to potentially be able to sell these for cash.

But how could this work in practice?

Second-hand annuities for sale

After decades of saving to build a respectable pension fund, many savers then surrender this pot of cash to insurance companies, in return for a guaranteed income for life in the form of an annuity. Currently, around 400,000 British workers retire each year, and there are around six million 'legacy' annuity contracts in force, paying out £11 billion a year to around five million pensioners.

But when new pension freedoms come into force this April, pensioners with existing annuities will not benefit. The pensions minister Steve Webb wants to address this by allowing those who would prefer a lump sum to 'swap' their annuity for cash.

Compare savings rates

The pros and cons of annuity trading

Swapping a modest monthly income for a hefty lump sum might sound like a winner for many pensioners. However, Tom McPhail, head of pensions research at investment adviser Hargreaves Lansdown, cautions that there are many hidden pitfalls.

McPhail warns: "There are two possible ways this could be done and, whilst they are superficially attractive, we doubt either of them will be workable."

These are the two possible avenues open to the government.

1. Cancel your existing contract

This is where annuitant and insurer jointly agree to cancel the contract. Monthly or yearly payouts cease and, in return, the provider pays a lump sum to the pensioner.

This is the simplest solution but, crucially, depends upon both annuity provider and pensioner agreeing a fair price for the cancellation. The average person would likely need some form of advice in order to work out whether the deal being offered is actually fair.

McPhail suggests that that the fees for this advice would likely price out all but the most well-off pensioners.

What's more, this trade would force annuity sellers to undergo medical examinations in order to assess life expectancy. Otherwise, investors in poor health would try to cash in their annuities, leaving insurers with only healthy, long-lived pensioners, which would threaten their long-term solvency.

Most importantly, 'people tend to underestimate their life expectancy, undervalue long-term income, and overvalue up-front lump sums. This could easily lure many pensioners into making bad deals when re-selling their annuities.

2. Sell your existing annuity to a third party

In this scenario, a pensioner sells their annuity income to a third-party investor, in exchange for a lump sum. It is highly unlikely that individual investors would be sophisticated enough to buy individual annuities, so this would be a market dominated by investment firms.

Again, there is the risk that professional investors gain at the expense of people with annuities.

This second option resembles the 'life settlement' market, where second-hand life-insurance policies were traded. This took off in America, but ran into problems here in the UK.

The financial regulator at the time, the Financial Services Authority, described such schemes as "high-risk, toxic products".

For people with annuities to sell to the highest bidder, we would need a competitive marketplace to match sellers to buyers. While this could easily be done online, no such market exists today, with no obvious incentives to invent one.

Likewise, to spread their risk, professional investors would need to buy a portfolio of annuities, rather than a single contract. This would require the creation of 'pooled' annuity funds, adding yet another level of complexity.

Keep track of how your investments are performing with lovemoney.com’s Plans service