It is difficult to believe that annuity rates were somewhere around 16% in 1990, with the comparable rate today being something around 5%.
At historic rates a degree of ‘value’ was set, but it has been a downhill journey ever since. I’m often asked if I have any feeling for the future of annuity rates. It is obviously difficult to say with certainty, but the following factors do not look positive:
As I write, I note that gilt yields have gone up to their highest level since 2011 and this could well be reflected in annuity rates, but by very little.
Annuities have been around for a long time and for many years were the only way of converting pension funds into an income stream. At 16% this was not bad, but at 5% it does not look so good. The question is, do retirees fundamentally misunderstand the nature of annuities?
Annuities are an insurance contract against long life, not an investment contract. With an insurance contract the expectation must be the payment of the sum assured, and that is what annuities do. They are based on averages, although with the growth in enhanced annuities more and more people are being underwritten and being offered their own specific rate.
If an annuitant thinks he will live longer than the average life expectancy, then he will receive more than his money back. If he dies sooner, then some of this will be allocated to those who live longer. The oft-quoted example is Henry Allingham, the WW1 veteran who died age 113 after having an annuity for 48 years. Those who do live longer will see their annuity contract improve if viewed as an investment contract, as the mortality subsidy makes it harder to match the underlying investment return.
Buying an annuity is a big decision or, as the press has inferred, a ‘gamble’. But going into income drawdown (the alternative) and not understanding investment risk is also a gamble. At least the annuity gamble will give you an income as long as you live, whilst in theory the drawdown gamble could mean a significant drop in income before death.
(For an interesting read, consider “Why Don't People Insure Late Life Consumption? A Framing Explanation of the Under-Annuitization Puzzle” a 2008 US paper which suggests that consumers evaluate annuities in a narrow ‘investment frame’ that focuses on risk and return, rather than a ‘consumption frame’ that considers the consequences of lifelong consumption. The paper considers that, in an investment frame, annuities are quite unattractive, exhibiting high risk without high returns.)
I think there are a couple of things we could look at for the future:
One of the current demands is for more transparency in annuity products and perhaps it is time for insurers to open the ‘black box’ to show how the numbers work.
Annuities will always have an important place in retirement planning, but it is essential that we understand their role and the solution they can provide.
Innovation in this area will be welcome.
Mike Morrison
Head of Platform Marketing
AJ Bell