1
Contents Summary Introduction Are annuities fairly priced? Is the FSA doing enough to help people understand the choices? So what is the problem? Rates in today s markets Is this trend irreversible? Can the trend continue? The current economic position Where are we going? So should today s retiree buy an inflation linked annuity? If annuity levels are at a historic low point, what can be done? How many people even know about the alternatives? What investors need to do Conclusion Getting a tailored report About DMP Disclaimer References 2 3 4 5 5 5 6 7 7 8 9 10 11 14 16 17 18 19 19 20
Summary 1. Annuities in the UK are at a historically low level arguably at a level where it is difficult to see them going lower. 2. People buying annuities fix their income level for life at the time they buy the annuity. 3. As such people buying annuities today may be entering into a contract to buy their income for life on the worst possible terms. 4. Background information suggests that annuity rates could escalate very quickly and to levels which may surprise. 5. DMP Financial predicts that annuity rates could rise by 50% within the next ten years. 6. Alternatives to the purchase of an annuity are not well known. 7. Alternatives allow for individuals to get an income now but still retain the option to capture higher rates later down the line. 8. Anyone buying an annuity, thinking of buying an annuity or being advised to buy an annuity should stop and carefully consider the options and the background facts before committing themselves. 9. All people looking to buy annuities should get a tailored report on their own situation comparing and contrasting the various options. Finally higher inflation creates a double whammy for people buying annuities. They are going to see a rapid reduction in the spending power of their income (annuity) and higher inflation suggests higher future interest rates which means higher future annuity rates, which today s buyer will not benefit from. 3
Introduction At present, around 650,000 people reach the traditional retirement age of 65 every year in the UK.(1) Somewhere between 450,000 and 500,000 (2) annuities are purchased every year at current levels, this number is rising and will probably rise at a faster pace than in the past with the rapidly declining number of final salary pension schemes and government legislative changes favouring self provision. Assuming that a significant majority of these 65 year olds are retiring, annuity purchases represent the most significant part of the market for people who are converting their pensions into income. The decisions that individuals need to make when they come to buy an annuity include factoring in whether to take a guaranteed income for a set period, whether to build in a spouse s pension, to have a level or escalating income. The question of when the annuity should be purchased is rarely considered because most people will be buying their annuity at a set date (i.e. when they retire). However it may be the case that many individuals would be better off delaying their annuity purchase to wait for a higher income level. Recent research shows that many people would be prepared to do this if they could find a flexible solution which provided them with some income and some certainty in the intervening period. This paper analyses whether we are now in a period where many individuals would be better off deferring their annuity purchase and finding a flexible solution in the interim. 4
Are annuities fairly priced? This paper does not suggest that annuities are priced unfairly. According to an academic study conducted in early 2010 by the Exeter Business School, annuities are generally fairly priced. This means that the insurance companies are calculating and offering annuities to those retiring at a level that is calculated in line with the appropriate Gilt yields and mortality rates that make up an annuity rate. Put another way entirely the providers of annuities are playing fair with their customers! Is the FSA doing enough to help people understand the choices? Again this paper is not questioning the efforts being made by the regulator the Financial Services Authority to help consumers, the opposite is true, the FSA is making huge effort to ensure that consumers have the proper choices presented to them in an understandable and logical fashion. Likewise, the FSA is stipulating that insurance companies offering annuities actively bring all the options available in the market place to the attention of their customer s. So what is the problem? The problem is the market. The market rate for annuities has fallen so low that today s annuitants (people who are looking to buy annuities now and in the next year or two) are doing so at a market rate which is demonstrably low by historical standards. This means that today s retiree buying an annuity locks in this low rate for the rest of their life and they cannot escape this rate in the future. 5
Rates in today s markets The current annuity rate in the market is 6.27%. (3) This is the market rate based on a male life age 65, with a level income payable for life but guaranteed for 5 years (so if someone unfortunately dies the day after they buy the annuity, a payment is made for a minimum of 5 years to their Estate or Beneficiary). 6.27% may seem an attractive interest rate given current base rates which are near to zero (the official base rate is 0.5% at the time of writing). However 6.27% is not the interest rate, because it includes a very large element of returning the capital to the annuitant. In other words most of the rate (of 6.27%) is a return of the individual s own money back to them. Compare annuity rate levels over the past 20 years at 5 yearly intervals: 1990: 15.64% 1995: 11.09% 2000: 9.12% 2005: 7.09% 2010: 6.27% The decline in rates is clear. This can be attributed to a combination of decreasing interest rates (and more significantly decreasing Gilt yields and Corporate Bond yields) and escalating life expectancy. Whatever the reason, it is clear that someone retiring in 1990 would have been able to secure an annual income of 1,564 per year/ 10,000 whereas today the same situation provides an annual income of 627 per year/ 10,000. This drop of 60% in 20 years is a terrible position for today s retirees to face. WARNING! Low annuity rates! 66
Is this trend irreversible? No. There is nothing to say that this trend will continue and this paper is designed to alert people retiring to the very significant possibility that this trend may be reversed. People retiring in 2010 and the years immediately after may get caught in a trap whereby they buy an annuity only to find that rates subsequently improve, leaving them locked in to a comparably lower rate. Can the trend continue? Is the opposite true, could the trend actually continue and rates decline further? Yes! But we think this is unlikely and the balance of probability is in the other direction. However despite the very low current rate there is a possibility that rates may continue to decline we see this as being marginal. Rates seem to be close to a historic low and also to a theoretical floor where on a technical analysis it is hard to see how rates can fall much further. One simple (and we stress the word simple here) reason for this is as follows: Annuity rates are calculated using quite complex mathematical formula, which includes (again in simple terms) a mix of current Gilt (or Corporate Bond) yields and life expectancy. The insurance company paying the annuity calculates how long (based on averages) they expect to pay the annuity to any individual buying the annuity. So a male aged 65 buying a single life annuity has a life expectancy which may be as high as 85 in the current market. This means that the insurance company expects to pay the 627 for 20 years, a quick calculation will show that this is about 15,000. The reason this calculation seems so unfavourable to the annuitant is that Gilt yields are at historic lows and that the insurance company takes on board the risk of paying for longer periods than expected and also organises the averaging across the totality of all investors buying their annuities. There is another relevant point here: the increase in awareness of the best annuity rates and the better options as well as tailored annuities (for example higher annuity rates for those with below average health) works against the annuity providers. 7
In the old days companies offering annuities profited greatly from those people who died earlier than expected and used this profit to improve annuity rates across the board. However as the market has seen better buying decisions emerge, fewer of the annuitants who bought annuities on unfavourable terms now come into the mix, creating less profitability for the annuity companies making overall rates comparably lower. Overall, these points do stress that the levels are touching a lowness which cannot be seen as anything other than a point close to the floor. The current economic position It is dangerous and probably foolish to make any attempt to second guess the current market position; however there is no doubt that many commentators and experts consider that both Gilts and Corporate Bonds are currently in bubble territory. This means that investors (which will include Insurance Companies funding annuities) are probably paying top dollar for current gilt and corporate bond issues. This means that the yield on them is exceptionally low. Bubble in Corporate Bond and Gilt Prices = low yields = low annuity rates. The more the bubble is a reality, the higher the price for such investments, the worse the position for annuity levels. Some other commentators will argue that there is no bubble, but it does seem unarguable that rates are close to their all time historic lows. Corporate Bonds and Gilts are interest rate sensitive, the price of these assets will generally increase as interest rates fall and will generally decrease as interest rates rise. With base rates at such a low point, the only real way for rates to go is up. Of course Gilt and Corporate Bond markets look forward and try to price this in, but there is no doubt that currently there is no price built in for any significant long term interest rate increases. Technically annuity rates seem to be at a low point; economically this is also the case. Both of these statement can (and possibly should) be challenged, the trend in annuity rates however is crystal clear and is a matter of historical fact and this cannot be challenged. We are stressing the future possible range of prices, which we believe are balanced in favour of higher prices. This does not mean prices WILL be higher, but that they are more likely to be higher than lower. 8
Where are we going? What the reader has to understand is this: there is a very real possibility (according to our research) that over the coming 5-10 years annuity rates will rise and possibly significantly. Anyone buying an annuity today at 6.27%/ 10,000 has to factor in the possibility that rates could he higher in 10 years time and that these higher rates could be back towards previously high levels (i.e. above 10%/ 10,000). Anyone ignoring this would be wise to look back to commentaries from the period in the late 1990s and early 2000s the idea of a base rate less than 1% was risible according to many of the commentaries we have read. But less than 10 years later this is what has happened. The idea of a base rate of 6% may seem to be fantasy given today s current economic back drop, but no more so than the base rate of 1% or lower was to people thinking about the future 10 years ago. And this is where we need to talk about inflation. Because today (November 2010) the battle is raging (or is it?) between inflation and deflation. In many respects at the time of writing the only battle is between those that think we are heading into a deflationary period and those that think we are heading into an inflationary period. In reality we are currently in an inflationary period, which can be evidenced by looking at any recent graph of the Retail Price Index (RPI), the true measure of price increases. RPI is currently 4.6% (4) and is climbing. Inflation is a doubly whammy for anyone buying an annuity today, imagine a scenario where an annuitant buys their annuity today at 6.27%/ 10,000. They will lock in a lifetime income of 627 per year (not increasing). Now imagine an inflation rate of 4.6%, in ten years the income will now be worth less than 300 per year to that same person. So at age 75, the person will have seen their income half or worse... however this isn t the end of it. Surely with a sustained period of inflation averaging this level (4.6% per year) the government and central bank will have to take protective measures, which will only be achieved through serious interest rate increases. To combat inflation the only real weapon central banks have is interest rates. In short, if interest rates rise, it is very likely that annuity rates will rise. 9
So should today s retiree buy an inflation linked annuity? It may be but it is unlikely, simply because we now need to look at the rate per 10,000 that the 65 year old male can buy their annuity if they build in inflation protection. Remember the current market rate for a level annuity is 627/ 10,000. The rate for an RPI linked annuity? 406/ 10,000 - One third lower! It takes a long time for any individual to see their money returned on this formula (obviously it depends on the RPI) but it could easily be 20 years and the irony here is that the higher the rate of inflation the quicker they will break even or get their money back but this has to be offset by the likelihood that if they deferred their purchase they could probably get a better rate in a few years time on their purchase. Overall there are surprisingly strong links between inflation rates, interest rates, gilt yields and annuity rates and we can judge from long term trends what may happen to each based on the others. The threat of higher inflation and the realisation of higher inflation are highly likely to result in higher annuity rates even if there is a time lag. Put the RPI chart over the annuity chart and you will see that there is a correlation if you think that Quantitative Easing and the overall measures being taken by the UK government are likely to result in a sustained period of higher RPI then annuity rates are likely to rise in the next few years. To keep RPI under control at some point in the next 5 years the UK government (or central bank) will have to increase interest rates in this scenario. We believe there is a better than 50% chance that base rates will be back up towards 5% in the next five years. Since 1960 (i.e. in the past 50 years) base rates have been over this figure more than 80% of the time, clearly demonstrating the exceptional nature of the current period. 10
Just as the retiree in 2000 who bought an annuity is enjoying a level of income about 50% higher than today s retiree, so the next generation may find the opposite effect, they will enjoy a higher income. In modern times we have not seen this effect, it is 20 years since rates rose but there must be a chance that this is the defining point in the trend where the reversal will take place. If annuity levels are at a historic low point, what can be done? People looking to buy annuities today and in the near future are running a high risk of locking into their purchase at a historic low point and once locked in are stuck. They can therefore beat this by deferring their purchase and waiting a few years for a better rate. However this may fall down as a tactical approach on at least two counts: 1. Someone retiring may need the annuity for their income requirement; they may not be able to defer their purchase. 2. The possible loss of income whilst they are waiting may not be made up by their improved level later on down the line. This second point can be demonstrated by a simple calculation: The current level is 670 per year/ 10,000 purchase price. If this improved to 750 per year/ 10,000 after a two year wait, there is an increase of over 10% on the income level, but the two years in between the 670 p.a. has been lost ( 670 x 2 = 1,340). For a lifetime improvement of 80 per year there is a short term loss of money of 1,340. This means it will take 17 years before the person is up on the deal. 11
Income levels/rates would have to improve a lot for this calculation to start looking attractive. The solution that works is a different one: investors buying an annuity need to be able to access the income, but keep the possibility of an improved rate available. This can be done. Instead of buying an annuity an individual can enter into an income withdrawal arrangement (sometimes known as income drawdown or phased retirement). However for smaller sums (typically 50,000 or less, but there is no rule) this generally doesn t work, alternatively for many it doesn t work due to the added risk this entails on keeping the money intact. A more viable alternative for many may be a variable annuity or a flexible annuity. This is one which produces an income often at a similar level to a conventional annuity but retains a connection with ongoing annuity rates as time progresses. This document is not one which wishes to examine the detail of the alternatives nor the pros and cons. We do this elsewhere (for example see our document entitled The New Retirement Income Option, CLICK HERE for more details). If you are close to retirement you should survey all of your options before commiting to any retirement income solution. One of DMP Financial s affiliated specialists can help you consider all of your options and help you make an appropriate decision regarding your retirement income options. To arrange a free consultation: Call Freephone 08000 884570 or visit www.dmpfinancial.co.uk 12
Thanks to the work done by the media and the FSA there is now a general awareness that annuities need to be bought with great care. The internet is awash with companies offering annuity comparison services and the FSA has made sure that insurance companies are informing possible annuitants of the availability of the open market option which gives every person buying an annuity the right to secure the best current market rate. However despite all of this there is a worrying sign that annuitants are not aware of all the options, this is born out by two background pieces of information... 13 13
How many people even know about the alternatives? 1. The market statistics: Currently the number of people buying annuities compared to the alternatives can be shown as: 2009 Figures Number of annuities bought: 450,000 (5) Number of income withdrawal plans started: 24,513 (6) No of alternative annuities bought (e.g. variable annuities): 14,300 (7) There is some doubt about the authenticity of the figures in each case because different bodies show slightly different figures. However the overall position does not vary: conventional annuities dominate the overall picture, accounting for approximately 90% of the total market, with a small split between the two other methods. 14
2. DMP Surveys: DMP have studied this market through 2010 and have found some worrying numbers about the awareness of the alternatives: Only 21% of people approaching retirement know of the availability of an alternative option to a conventional annuity. (8) Only 29% of advisers helping people at the point of retirement will consider and compare the alternatives. (8) In the US, over 50% of comparable retirement income purchases involve some type of alternative annuity such as a deferred or variable annuity. (9) Although the UK and the US vary in many ways with their economic and financial markets, they do compare in many other ways and the basic mathematical formulas that investors are considering when converting their money (most typically a pension fund) into an annuity are almost identical. For example, interest rates are broadly the same, mortality levels are about the same and income requirements are about the same. One difference lies in the financial advisory market where fiduciaries in the US are generally more advanced in their practices than in the UK. A simple search on the internet will show this. Look at any search concerning annuities and options at retirement and the stark differences between advisory firms in the two countries become apparent. This is not a pop at the UK financial services market there are advisers in the UK doing what needs to be done, but it appears that there is not the widespread standard practice that there is in the US. If we look at other areas of financial planning, for example stakeholder style pensions, passive investment practices, the use of wrap technology, we can see the US is often a few years ahead of the UK market and there are numerous examples of the UK following where the US has led. We suspect that we will see a similar shift in this area. 15 15
What investors need to do We believe there is a simple solution for anyone looking to buy an annuity: Get a tailored report. What will this look like? Firstly it will compare all the options, not just annuity vs. income withdrawal. It will need to consider alternative annuities, including variable annuities often described as third way products. Secondly it will need to address the fundamental mathematics of why buying an annuity today may be a costly error, but the report will need to demonstrate this to the individual in a mathematical way (this doesn t need to be complex, some simple comparative figures will show the risks of each alternative). The tailored report will need to include an assessment of the individual s health, tax and family position, their income requirements as they fluctuate through retirement (assessed) and their propensity to take on risk of any description. Thirdly the report should summarise the best likely outcome of the annuity in an environment of rapidly increasing annuity rates. We are not saying that annuity rates will escalate, we think the chances are high (maybe higher than many realise) that they will and it is for this reason that investors should plan with this in mind. A conventional annuity once purchased cannot be reversed; it is fixed at the prevailing rate. The alternatives do not suffer this disadvantage and for this reason alone individuals should definitely stop for reflection before buying an annuity. 16
Conclusion Nowhere in this research document do we conclude that UK investors should be pouring into the alternatives. We are however concluding that UK investors who are looking to purchase an annuity should stop and take heed; there is a very real chance that rates are close to or at their historic lows. This means that investors may be better finding a holding position for a period whilst rates improve. It is clear that the alternatives which allow for this approach are not properly understood and therefore, logically, people are not acting with the benefit of all the facts and figures. For many this could prove costly and if there is any lesson from the past few years is that investors and their advisers should act only after appropriate due diligence has taken place. We believe that for the circa half a million people affected by this in a typical year (and this figure is probably rising) the best approach is to make a decision only after a tailored report has been produced considering these alternatives alongside each other. 17 17
Getting a tailored report A retirees source(s) of income will define their standard of living more than any other factor. It is therefore vital that pre-retirees and retirees make the right financial choices in regard to their sources of retirement income. No individuals situations are the same and the appropriate way forward will often only become clear once an individual review has taken place. This review will take into account the options available in the marketplace and an individual s circumstances. Any such review can only be conducted by a regulated independent source of financial advice. If you are close to retirement or retired, DMP Financial has established a national network of carefully sourced specialist advisers who can help you make appropriate financial decisions by conducting a tailored no obligation report for you. DMP s specialist advisers are: - Carefully selected - Independent - Experienced - Located across the UK - Regulated by the FSA - Supported by our staff who do all the organisational work on your behalf To get a no obligation report by one of DMP s specialist advisers please visit www.dmpfinancial.co.uk or contact us on Freephone: 08000 884570. 18
About DMP DMP Financial operates a number of web sites on a range of subjects relating to money and personal finances. The company works to the maxim money information, money education and money inspiration and through its web sites and guides, DMP looks to provide valuable easy-to-understand information to consumers of financial services. It is absolutely essential that consumers receive appropriate independent financial advice. DMP specialises in connecting consumers to specialist advisers but the company itself is not regulated and does not give advice. Disclaimer DMP Financial Ltd itself does not provide advice. DMP always recommends that any financial transaction, advice or decision should only be taken once proper, independent, regulated advice has been sought and taken. DMP cannot be responsible for any of the advice given by such a specialist. The company will always aim to ensure that it provides accurate and reliable information, but cannot be held responsible should a reader or viewer of any information rely on such information without separately taking advice from an appropriate, regulated source. 19
References (1) Age UK (2) 450,000 (source Retirement Solutions) Half a million (Source www.annuity-rates.org) Half a million (source: ukannuityleads.co.uk) (3) www.williamburrows.com - charts October 2010 (4) National Statistics Office (5) Various sources e.g. annuity-rates.org; Retirement Solutions; UK annuity leads (6) Association of British Insurers (7) Towers Watson (8) DMP retirement surveys 2010. DMP surveyed 318 retirees and 106 IFA firms to gain a level of understanding about the awareness of the available alternatives. (9) US Securities and Exchange Commission (10) DMP analysis of Bank of England statistics, http://www. bankofengland.co.uk/publications/index.htm 20