Laith Khalaf: "If annuities didn't exist, we would certainly have to invent them, but that still doesn't mean people want to buy them."
Rising bond yields have pushed annuity rates up 20% this year meaning 'income for life' is no longer completely out of favour, but as Laith Khalaf writes, the market is unlikely to regain its former dominance.
There was a time when 90% of retiring investors bought an annuity with their pension pot, before the pension freedoms ushered in a new era of individual retirement responsibility in 2015.
The result hasn't been a cavalcade of Lamborghinis hitting the streets of Eastbourne, but rather most people now choose to invest their pension or simply withdraw it as a lump sum, with only 10% buying an annuity. But do higher interest rates mean all that is about to change?
As a result of rising bond yields, annuity rates have increased by around 20% this year. Based on a £100,000 pension pot, a 65-year-old can now get an annual income of £5,970.
A 6% income may sound extremely attractive to many investors, who are perhaps used to a dividend yield from the stock market of around 3% to 4%.
But of course, there is a key difference between investment income and annuity income which means it's not a like-for-like comparison. If you receive dividends from shares or funds, you still also have your capital invested which can be drawn down.
A 6% annuity rate includes your capital being fed back to you, for the rest of your life. And while we know death and taxes are certain, their timing is not. If you live a long time, an annuity might be an extremely good choice. But if you die early, you may not get much of your money back, and unlike keeping your pension invested, there isn't normally a lump sum left to pass on to beneficiaries.
Uncompelling?
In that context, 6% doesn't sound like a particularly compelling offering, particularly when you consider that is a level rate, fixed for life, and inflation is currently entering the stratosphere. At 2% inflation, an annual income of £5,970 would only be worth £4,900 in 10 years' time, and £4,020 in 20 years' time.
If you feel generous about the Bank of England's ability to bring inflation back down in the longer term, sticking two years of double-digit inflation at the beginning of that equation makes things look even less attractive. Hence why if you opt for an annuity that rises in line with inflation, a 65-year-old with a £100,000 pension pot would get a starting annuity of just 3.2% (all rates are from MoneyHelper).
It would be remarkable for the 20% rise we have seen in annuity rates this year to have absolutely no effect on their popularity. But I would argue the increase in pension savers attracted to annuities is still likely to be marginal.
Even when 90% of people bought an annuity, many of them did so begrudgingly.
People really don't like the fact that if you get hit by a bus the day after you buy your annuity, all the money you have saved up over the years might bite the dust too.
Keeping your money invested in your pension is risky, but it also has benefits, like hopefully seeing your money continue to grow, passing what's left of your pension savings on to your family after you die, and managing your income to suit your retirement needs, and keep your tax bill in check.
Biting point
There undoubtedly comes a biting point when annuity rates are simply too attractive to ignore, but we're still some way from that being the case. Gilt yields are still low compared to the pre-financial crisis era, but a recession is looming, and the Bank of England will have to ease off the interest rate throttle at some point in the not-too-distant future.
The central bank is starting to unwind QE, but at a glacial pace. The result is we shouldn't count our chickens before they're hatched on the direction for bond yields. Perhaps the bonfire of EU regulations and specifically the Solvency II rules governing the capital requirements of insurance companies will drive substantially higher annuity rates, but somehow, I doubt it.
No, the golden age of the annuity is in the rearview mirror, and now the pension freedoms genie is out of the bottle, it's not going back in.
Annuities still do a job alongside final salary benefits and the state pension of paying a baseline of secure income, but they've never been well-liked. A guaranteed income for life can be a very valuable thing, and probably a very undervalued thing, but people still don't like to gamble on life expectancy with all the savings they've spent their life building up.
If annuities didn't exist, we would certainly have to invent them, but that still doesn't mean people want to buy them.
Laith Khalaf is head of investment analysis at AJ Bell
