Where now for annuities?
Would-be retirees hoping to trade in their pensions pot for an annuity should not get too excited. The income on offer from annuities - financial products that give you a guaranteed income for life when you retire - is not what is used to be when you started saving for your pension.
Numbers from Moneyfacts.co.uk highlight just how far annuities have fallen from glory. In February 1995, an individual with a £100,000 pension could have swapped it for a standard annuity that paid out £11,470 a year. Today, they would get a paltry £4,760.
Why have annuity rates fallen?
Annuity rates are linked to interest rates and the yields offered by government bonds, otherwise known as gilts. Both interest rates and gilt yields have been stuck in the doldrums for a prolonged period. To make them even less attractive, annuities don’t pass on the capital sum in your pension to your loved ones when you die, and most annuities don’t pass on income either.
This backdrop is why the new pension freedoms, now marking their first anniversary, were so ubiquitously welcomed. Under the old rules, pensioners had to buy an annuity or take an income directly from the pension that was restricted to the level of an annuity.
But George Osborne’s shake-up back in April 2015 means everyone, from age 55, can now do as they see fit with their nest egg. You can take as much or as little income and capital from the pension fund as you like.
Figures from trade body the Association of British Insurers show how retirees have embraced the looser rules. Between April and September 2015, during the first six months of the new freedoms, £2.17 billion was invested in annuities. This marked a steep 33% fall on the tally for the same period in 2014.
Value versus security
While recent history has not been kind to annuities, many people still value the security of a guaranteed regular income.
Patrick Connolly, a chartered financial planner at Chase de Vere, acknowledges there is a common perception that annuities are poor value. But he warns that people need to look at the bigger picture.
He says: “You need to remember that we are in a low interest rate environment and we’re likely to be there for some time. This means it is difficult to generate a decent level of income from other products without taking more risk. For many people, it is better to accept a lower annuity rate than a higher-risk product, which could put their future standard of living in danger.”
While Justin Modray, founder of Candid Financial Advice, does not believe annuities offer good value given the current deals on offer, he does feel “they remain a sensible option for those who want the peace of mind of a guaranteed income”.
It is worth noting that the government has plans in place to extend the freedoms by allowing pensioners with an annuity to swap their income for a cash sum or other pension product. How this will play out still remains to be seen.
Despite the rigid nature of annuities, they come in a number of guises.
Single-life annuities are the most common and, as the name suggests, they simply pay an income to you.
Joint-life annuities pay you until you die, after which the income would go to your partner, until such time as they die.
Inflation-linked or escalating annuities pay out an income rising in line with the cost of living. This could be useful if you live a long time and high inflation comes back. The downside is that the cash paid out initially is generally far lower than that of a regular annuity and it could take years to catch up.
Guaranteed annuities pay out to your family after you die for a set number of years.
Getting the best deal
If you feel an annuity would suit you, as with all big purchases, it is vital you seek out the best deal. You do not need to go with the deal that your pension provider offers you, so shop around.
The Financial Conduct Authority, which regulates financial firms, highlights that a massive eight out of 10 people who opted for an annuity from their existing provider would have received a higher income if they had scoured the competition for a better deal.
“By checking the market you could easily improve your income by 30% or even more,” says Andrew Tully, pensions technical director at Retirement Advantage.
Drawing an income direct
Income drawdown is a very different beast to an annuity, but it can give you much greater control and flexibility over your finances in retirement. Income drawdown allows you to take an income from your pension, while keeping the capital invested.
Tellingly, while interest in annuities has certainly eased, interest in income drawdown has soared. In the first six months since the new pension rules were brought in, £2.85 billion has been invested in income drawdown products, up from £1.64 billion during the same period in 2014.
The goal with income drawdown is to be able to comfortably take an income and at least keep the size of your pot steady, if not grow it in line with inflation.
With this added flexibility comes much greater risk, as your cash remains at the mercy of markets. Worst case, you could lose all of your money if you withdraw too much and/or markets take a turn for the worse.
Whether income drawdown is right for you will be dictated by a number of factors, such as how much risk you are willing to stomach as well as your overall financial backdrop. Do you still have debts to pay off, such as your mortgage? Do you have other sources of income at your disposal too, aside from the state pension?
Typically, experts recommend that only those with a pension pot of £100,000 or more should consider drawdown. But if you have alternative income sources, it can be done with less. In contrast to annuities, income drawdown allows you to pass on your remaining cash to your loved ones when you die.
Remember, though, you can use some of your pension to purchase an annuity, perhaps to secure a minimum level of income, and use the rest to go into an income drawdown scheme. The two styles are not mutually exclusive.
How does it work?
Most personal pensions and many workplace schemes offer retirees the option to go into income drawdown. If you are unsure of your situation, do check.
You may need to transfer your pension into a self- invested personal pension, better known as a Sipp.This is just another type of tax-efficient pension wrapper, in which you can put a huge variety of investment funds and shares to suit your needs and risk tolerance.
If your workplace plan carries a drawdown option, it may be best staying put, provided it has sufficient investment options. But if you plan to switch out, ensure you don’t lose out on any financially lucrative benefits.
As it should be with any investment decision, before you dive in, take a good, hard look at what you want to achieve. Do you want to achieve income or growth – or a combination of the two? If you are not planning on taking an income for a few years, you could look to grow your pension pot further.
You can always keep paying into your pension, although the lifetime limit, the maximum you can save in your lifetime, falls to £1 million from 6 April 2016 and anything above the threshold will be hit with a tax penalty.
Your best case scenario should be living off the natural yield delivered by the underlying investments. That way, you are not eating into the original capital. Experts generally recommend that drawing a modest 4% to 5% a year is sensible.
What you absolutely do not want to happen is for your money to run out, and bear in mind you could easily live another 30 years after you retire. Select a broad range of investments, such as equity, bond and property funds, which are unlikely to all move in tandem.
This will help your portfolio weather stormier market conditions, but you will always need to review your portfolio regularly.
For the best Sipp deals, go to an online broker, such as Interactive Investor or Hargreaves Lansdown. The good news is that, typically, most providers charge you nothing for opening an account. Beyond that, there are primarily two costs to consider, that levied by the Sipp provider, and the underlying investments.
Providers levy an annual management charge, usually a flat fee or a percentage of the value of your pot.
If your portfolio is quite substantial, say at least £100,000, you are probably better off choosing a flat fee.
While most Sipps do not tend to charge for buying and selling funds, they are likely to do so for buying and selling shares.
You will also have to pay a platform fee for holding funds, plus the annual cost of the fund itself. Expect to pay around 0.1% a year for simple tracker funds that replicate performance of a particular market such as the FTSE All Share index of UK companies. Active funds, run by a stock-picking manager, charge nearer to the 1% mark.
Comparefundplatforms.com is a good one-stop shop for assessing charges.
If you are unsure about managing your own income drawdown plan, you could get an independent financial adviser to do it for you, but naturally this will incur extra costs.
If you have the time and patience and are prepared to take the DIY route, there is no shortage of online guides, tools and recommended portfolios for all risk appetites available from a variety of Sipp providers.
Where might annuity rates go from here?
Savers hoping to see annuity payments drastically improve sometime soon may be in for a long wait.
Richard Eagling, head of pensions at Moneyfacts.co.uk, says: “Gilt yields remain the key influence on annuity rates, so the extent to which annuity rates may recover will depend on whether yields increase in the coming months. All in all, without a substantial uplift in gilt yields low annuity rates are likely to persist for some time to come.”
Whitchurch Securities’ Mark Stone believes, given the continued low interest rate environment and the negative effect of pension freedoms on annuity sales, annuity rates could even conceivably go downwards.
But Retirement Advantages’ Andrew Tully is slightly more upbeat and believes they will pick up.“ The key question is when,”he says.“The medium-term outlook is that interest rates will rise, and we might see gilt yields improving. If so, then annuity rates will pick up.”
Could you get an enhanced annuity?
There is a way to potentially boost what you get. Standard annuity rates are based on average life expectancy. To improve the annuity rates you’re offered, it is always worth being brutally honest about your health.
The reason for this, as Mark Stone, financial planning director at Whitechurch Securities, puts it, is that “you end up with the best rates that you possibly can, as all medical details are taken into account”.
Bluntly speaking, if an insurer thinks your life expectancy is below average, you could qualify for an enhanced annuity, and here you are likely to get a much better income rate because you are unlikely to be as much a burden on the provider’s purse as someone in good health. There can typically be a significant 30% gap between standard and enhanced annuity rates.
Jim Boyd, director of corporate affairs at pension firm Partnership, says: “Even something as manageable as high blood pressure, obesity or diabetes can make a real difference.”
Vanessa Owen, head of retirement solutions products at insurer LV=, adds: “Even if you think you’re healthy, if you’re a smoker, overweight or taking any medication, you could get a better rate.”
If you have the finances to hold on a while during retirement, it could also be worth your while postponing your purchase. However, by delaying you are banking on your annuity rate improving significantly, but you will be older so that will help improve your odds of a better deal.
Like a self-select ISA but for pensions, self-invested personal pension is a registered pension plan that gives you a flexible and tax-efficient method of preparing for your retirement. It gives you all sorts of options on how you put money in, how you invest it and how it’s paid out and offers a greater number of investment opportunities than if the fund was managed by a pension company. SIPPs are very flexible and allow investments such as quoted and unquoted shares, investment funds, cash deposits, commercial property and intangible property (i.e. copyrights, royalties, patents or carbon offsets). Not permitted are loans to members or people or companies connected to the SIPP holder, tangible moveable property (with the exception of tradable gold) and residential property.
Also known as index funds, tracker funds replicate the performance of a stockmarket index (such as the FTSE All Share Index) so they go up when the index goes up and down when it goes down. They can never return more than the index they track, but nor will they lose more than the index. Also, with no fund manager or expansive research and analysis to pay, tracker funds benefit from having lower charges than actively managed funds, with no initial charge and an annual charge of 0.5%.
The general term for the rate of income from an investment expressed as an annual percentage and based on its current market value. For example, if a corporate bond or gilt originally sold at £100 par value with a coupon of 10% is bought for £100 then the coupon and the yield are the same at 10%, or £10. But if an investor buys the bond for £125, its coupon is still 10% (or £10) and the investor receives £10 but as the investor bought the bond for £125 (not £100) the yield on the investment is 8%.
An alternative to an annuity, income drawdown (also known as an unsecured pension) allows you to take income from your pension fund while the fund remains invested and so continues to benefit from any fund growth. The drawdown of income has to be calculated carefully as taking too much income could exhaust the pension fund so experts say the annual drawdown must not exceed what the assets would normally yield in an average year. The invested pension fund could also be hit by market turbulence and the value of the assets could fall.
The familiar name given to securities issued by the British government and issued to raise money to bridge the gap between what the government spends and what it earns in tax revenue. Back in 1997, the entire stock of outstanding gilts was £275bn; by October 2010 it had surpassed £1,000bn. Gilts are issued throughout the year by the Debt Management Office and are essentially investment bonds backed by HM Treasury & Customs and considered a very safe investment because the British government has never defaulted on its debts and this security is reflected in the UK’s AAA-rating for its debt. Gilts work in a similar way to bonds and are another variant on fixed-income securities.
In exchange for any lump sum – usually your pension fund – an annuity is “bought” from an insurance company and provides an income for life. When you die, the income stops. Annuity rates fluctuate daily and depend on your sex (although from 21 December 2012 insurers will no longer be able to use gender as a factor when calculating annuities), age, health and a number of other factors, so you have to pick the right one and, once bought, its terms cannot be altered, so seek financial advice.
Association of British Insurers
Established in 1985, the ABI is the trade body for UK insurance companies. It has more than 400 member companies that provide around 90% of domestic insurance services sold in the UK. The ABI speaks out on issues of common interest and acts as an advocate for high standards of customer service in the insurance industry. The ABI is funded by the subscriptions of member companies.
Annual management charge
If you put money in an investment or pension fund, you’ll not only pay a fee when you initially invest (see Allocation Rate) but also a fee every year based on a percentage of the money the fund manages on your behalf. Known as the AMC, the actual percentage varies according to the particular fund, but the industry average for active managed funds is 1.5%.
An increase in the general level of prices that persists over a period of time. The inflation rate is a measure of the average change over a period, usually 12 months. If inflation is up 4%, this means the price of products and services is 4% higher than a year earlier, requiring we spend and extra 4% to buy the same things we bought 12 months ago and that any savings and investments must generate 4% (after any taxes) to keep pace with inflation. Since 2003, the Bank of England has used the consumer prices index (CPI) as its official measure of inflation (see also retail prices index).