You're wrong, annuities are good value

Matt Pitcher
7 February 2008

Annuities offer good value to anyone seeking an income from a modest pension fund. This belief has landed me in hot water with people before now. I remember clearly having a debate on BBC radio with a caller who became more and more irate at this claim despite the fact that I had no axe to grind or gained any benefit from making it.

His premise was that the annuity rate he could get at his age (mid-50s from memory) was far too low given that he was only going to live for another 15 years. When I pressed him on this point he conceded that he may live 20 years. He was multiplying the annuity rate by the number of years he had left and was right to say that he wouldn't receive all of his fund back.

I felt like asking him what condition he was suffering from. You see the issue with this debate is that most people drastically underestimate their own life expectancy.

As an example a man is likely to draw his pension at 65 currently, due to standard employer and state retirement ages. If he reached 65 in 2005 the Office for National Statistics (ONS)*1 gives him an average life expectancy of 82 and he could attain an annuity rate of 7.4%. This means that by taking a standard annuity with no frills and living to average life expectancy he regains 126% of his pension fund. As this income is guaranteed this is not a bad return on his money.

So what if his life expectancy is less due to a medical condition? Well the annuity company will recognise this and for the same man the maximum on offer would be 10.7%, indicating a return of the pension fund in a little over 9 years.

If a full female spouse's pension is included the rate for this gentleman falls to 6.3% but of course female life expectancy is better (85) than a man's and the annuity company is now taking a gamble on two lives. Magically with this reduced annuity rate as it lasts to 85 instead of 82 the return is still 126%.

So what about the effect of 17-20 years worth of inflation this income? Well annuity rates are low for two reasons, one is increasing life expectancy and the other is low interest rates and therefore low levels of inflation. If you believe that inflation is under control then a level income for the next 17-20 years might be a reasonable gamble as an inflation linked annuity for our couple drops to 3.8%. Otherwise buy the inflation linked annuity and benefit from the rise in your pension income.

I qualified my claim at the start by saying that an annuity represents good value for modest pension funds. Anyone with a fund of £150,000 plus has a wider choice of options that are too expensive for most funds below this level. However these options rely on investment returns and the good old fashioned annuity though much maligned offer a guaranteed long-term return that most investors would kill for in volatile times.

The future for annuity incomes may look bleak to most people as the ONS predicted male life expectancy growing to 21 years and female life expectancy 23 years by 2006. It is that rate of increase which will continue to drive annuity rates down even if interest rates rise in the future. Let's not miss the good news though that we can all look forward to living a lot longer and staying healthier than the generation that went before.


Matthew Pitcher is a wealth adviser and chartered financial planner at Towry Law Financial Service. He is also a Moneywise Ask the Professionals columnist.