The purchase of an annuity is one of the most important financial transactions of their life for most working people. Yet it is a subject that tends to confuse – perhaps because people avoid thinking clearly about retirement planning in the same way they try to ignore the idea of getting old.
An annuity is the income a person receives in retirement. The amount of income received from the annuity obviously depends on the size of the pension pot, but other factors include who the annuity is obtained from and the market rate at the time of retirement. Ideally, a person should convert their pension into an annuity at the right time – when annuity rates are favourable.
Annuities are in the headlines at present, because one of the first acts of the incoming Conservative/Liberal government has been to scrap the obligation to convert a pension pot into an annuity by the age of 75. There have been good reasons why governments have required elderly people to take out an annuity – it reduces the risk that the state may be left to subsidise them through means-tested benefits in old age.
But it can also make sense for someone to use their pension pot without converting it to an annuity. A person who is critically ill may want to use it in the short period of time before they die. Alternatively, a pensioner might want to buy investment assets with it to generate a higher income than the annuity would provide.
Annuities are complicated – which is why it is important to take expert professional advice. Sadly, very few people do. A survey just published by Prudential found that a mere 19% of people planning to retire this year intend to take financial advice on converting their pension into an annuity. Yet the cost of accepting a poorly performing annuity can be very high.
About 60% of people who retire accept the annuity that is linked to their existing pension plan. This is despite the fact that under the ‘open market option’ they can usually shop around for the best annuity on the market. They may also be able to delay the timing of their retirement to match a point when annuities offer a better rate.
Aviva is about to launch a TV advertising campaign explaining the benefits of going to the market for the best annuity – it claims that this may boost retirement income by 20%. For someone with even a fairly modest pension pot this might provide an extra £1,000 a year – which might add up to £20,000 over the rest of their life.
Both Prudential and Aviva are now trying to persuade more people approaching pension age to take financial advice to improve their retirement planning, including their choice of annuity. There are also now a wide range of web comparison sites that allow people to evaluate the annuities on offer – rates on offer vary not only according to providers, but also depend on other factors such as personal life expectancy and whether the pensioner intends to take an initial cash free lump sum.
But whatever advice is taken, the painful truth is that annuity rates are poor at present. Over the last 18 months, annuity rates have fallen by about 13%. Traditionally annuity rates have broadly tracked the rates paid by gilts (government bonds). That link seems to have been broken in recent times, with annuity rates falling even while gilt rates rose.
“There are a number of factors in play at present, all contributing to a decline in annuity rates,” says Tom McPhail, head of pensions research at advisors Hargreaves Lansdown. “Improving life expectancy continues to force insurers to adjust their payout terms as they have to stretch the income payments over longer periods. They don’t know when, or indeed if, this trend will run out of steam.”
In addition, says McPhail, people with serious health conditions are increasingly opting for individualised annuities on enhanced terms. The effect of this is the end of their ‘subsidy’ of the general annuity pool. Meanwhile, investment risk has risen and returns, generally, fallen.
It has become a bad time to retire. The real, question, though, is whether it will ever again be a good time to retire.
A Question of Money
Q. I see that Alliance & Leicester has become more integrated into the Santander network. I held £50,000 in savings in both Alliance & Leicester and Abbey, to ensure I maximised my protection under the Financial Services Compensation Scheme. Does the closer integration mean that I have lost this protection?
A. Yes. Santander has moved aggressively into the banking market in Northern Ireland and Great Britain, buying the Abbey, Alliance & Leicester and Bradford & Bingley brands. The Abbey and Bradford & Bingley brands were replaced as trading names earlier this year and are now known as Santander. The same process is now taking place with Alliance & Leicester, which will also be known as Santander. As part of this change, Alliance & Leicester will operate under the Santander banking licence. This means that where in the past customers of Abbey and Alliance & Leicester were subject to two separate protection limits of £50,000, from the end of this month they will be covered by a single limit of £50,000. If you want to benefit from the full Financial Services Compensation Scheme protection you should close one of your accounts and move it to an account with a competitor. Santander will not invoke financial penalties for those customers affected by this.