Back to basics: why are annuity rates falling?
Annuity rates have plunged to new lows following the result of the EU referendum. But why have they been hit so hard? We go back to basics to find out.
Annuity rates fell by more than 3% in the first two-weeks following the result of the Brexit vote.
Big providers in the industry such as Aviva, Just Retirement and Retirement Advantage, cut their rates and several negative rate adjustments have been announced across the industry since Brexit.
Research from Hargreaves Lansdown found that the best open market rate for guaranteed income for life for a 65-year-old fell by 3.59% in two weeks, meaning a standard terms policy offers an income of just £5,000 on a £100,000 pension fund.
In just eight years, those looking for an annuity now get 37% less than they would have received in July 2008.
But why has Brexit affected annuities and why are they falling?
Tom McPhail, head of retirement policy at Hargreaves Lansdown, said annuity rates may move in response to changing interest rates, however this is not certain.
“International and domestic demand for gilts (government bonds) and sterling denominated investment grade bonds will influence annuity rates, as will expectations of inflation and to a lesser degree, short-term interest rate movements,” he said.
Kate Smith, head of pensions at Aegon, said annuity rates are also affected by customer demand and regulation. However the two key factors are the yields on gilts and corporate bonds, and life expectancy.
Insurers price annuity rates in relation to yields on gilts and corporate bonds. UK gilt yields are currently at their lowest ever level having fallen to about 1% in recent weeks and even dipped into negative territory as a result of low interest rates, combined with investor’s search for low risk assets.
Traditionally in times of stock market volatility, government bonds are considered a safe way of preserving capital as the chance of a government not paying money back is low.
But the Brexit vote meant anxious investors flocked to government bonds, pushing up prices and pushing down yields. A 10-year gilt now yields about 0.8%, down from the 1.37% before the referendum vote, and 4.5% before the financial crisis, while the 30-year gilt yields about 1.6%.
As a result, yield-starved investors may now be considering a move up the risk spectrum to corporate bonds – slightly riskier than government bonds but with more attractive dividend yields. As with gilts, an increase in demand could push up their prices and pull down yields.
Smith said: “Annuity insurers buy gilts and bonds as they give predictable returns, meaning they are suited to annuities which provide a guaranteed income for life. If the returns on these investments are low when the customer buys the annuity, this is reflected in their annuity income and they will get less for their money.”
Turning to life expectancy, which also impacts annuity rates, Smith said this is increasing at around two and a half years per decade.
“Insurers have to consider the possibility that at age 65 more annuitants may live to 90 or even longer. As a result the level of income they provide must reflect the risk of paying out a lot more than the saver initially provided,” she said.
Annuity rate decrease – when should you buy?
McPhail said the answer is not to delay doing so just because today’s rates are lower than in the past.
“For many investors a mix and match strategy, putting some of their pension into an annuity and some into drawdown, may well be the best approach. As always, anyone buying an annuity should shop around for the best possible deal for their circumstances. It’s particularly important to provide health and lifestyle details to try and boost the income on offer,” he said,
However, Smith said it’s a terrible time to fix your retirement income by buying an annuity.
“People should hold off making any decisions to buy an annuity as this will lock them into a low retirement income. It might not be the option they envisioned but if they can, people might want to think about putting off retirement and continuing to work and save to see if rates turn a corner in the coming years.”
She shares the same view as McPhail on drawdown: “Alternatively those approaching retirement can opt for drawdown and keep their options open. This enables people to keep their money invested in the markets and take an income. It’s a flexible approach but there’s a trade-off to be had with the potential for investment volatility to reduce the value of their savings.”
Smith added that while people may think annuities are poor value because of falling gilt rates, it is possible annuity rates may bounce back and they will still play an important part in retirement income planning as they provide a guaranteed income for life.