Annuities: What now for retirement income?
A change in pension rules heralded in the chancellor's Budget speech means a retiree can now draw their entire pension in one go, if they wish. For some, the freedom will mean retirement planning that can better suit their needs. But what does it mean for the centuries-old annuity, and the security of an income for life which it provides?
A retirement annuity is an income that is bought once with a pension pot and lasts for the rest of the holder's life.
A pension company will work out how long the pensioner is likely to live and will offer an income. If the buyer lives longer than expected, the provider makes less money than anticipated, or a loss. If the buyer dies sooner, the pension firm often keeps the difference.
Annuities have been criticised by pensions experts such as campaigner Ros Altmann, who has said firms don't disclose how they calculate payments, and often add opaque fees.Choice
The changes will affect those over 55 who have savings in a defined contribution (DC) pension scheme, such as a personal pension. In a DC scheme, the pension depends on the amount of money you, and perhaps your employer, have saved in the scheme.
End Quote John Ball Towers Watson
Of those who choose not to buy annuities, many may enjoy better outcomes, but some will burn through their money too quickly, [because they can have ready access to all of it] and others will be too cautious.”
The main change is choice, as the choice of an annuity is not being prohibited, said Tom Kirchmaier, a fellow at the Financial Markets Group Research Centre at the London School of Economics and Political Science. Following the financial crisis and the low rates that followed that, the choice should help pensioners, he added.
"People actually had to buy an annuity during the downturn at its lowest point and got a bad deal,'' he said. "It fell upon you to take on a lot of risk you can't control.''
Criticism didn't only centre on the change to returns brought about by the financial crash. In February the Financial Conduct Authority, the City watchdog, concluded the pensions market was not working following a review into the "disorderly" annuities market, which shut out savers with smaller pensions and provided bad deals for loyal customers.
Annuity income could increase by 6.8% a year if people shopped around for an annuity, the FCA said.'Open market'
Many pension savers were, and are, unaware they could get an annuity from a firm other than the one that managed their investments, and shop around as they would with a savings account or mortgage.
"The overwhelming majority of people who buy an annuity from their existing provider could get a better deal on the open market, so [the Budget] announcement should help stop millions of people from losing out on thousands of pounds of retirement income,'' said Which? executive director Richard Lloyd.
Pension schemes explained
- Final-salary scheme: Guaranteed pension based on earnings at end of your career and length of service. Also known as defined benefit schemes
- Career average scheme: Guaranteed pension based on your average pay over your career
- Defined contribution scheme: Determined by contributions and investment returns. Usually worth less than final-salary pensions. Savings used to buy an annuity, or retirement income - until now
"The key to making this work will be a requirement on providers to give consumers high quality, impartial advice on their options across the whole of the market, with maximum protection at this critical time in their financial lives."
Giving people the choice of opting out of an annuity is likely to have some consequences, though. The first is it places people's long-term financial planning in their own hands, rather than having a professional take charge, said John Ball, UK head of pensions at pay consultant Towers Watson.
"Of those who choose not to buy annuities, many may enjoy better outcomes, but some will burn through their money too quickly, [because they can have ready access to all of it] and others will be too cautious about how much of their savings they allow themselves to withdraw and spend."
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One winner may be Chancellor George Osborne's Treasury. As soon as pension payments are made, they become taxable, said Ball.
"To the extent that people access more of their pension pot earlier in retirement, this will also mean paying tax sooner - that's why the government assumes the policy will raise £1.2bn in 2018-19. The flip side is that it will collect less tax from pensioners later in their retirement."
Another consequence is somewhat subtler.
The move will mean annuities will suffer from what economists and insurers call adverse selection, said Dr Kirchmaier. Those who are ill and feel they won't get the best from an annuity, a long-term investment by its nature, will most likely cash their investments in order to spend them or pass them on.
Because it is expected that healthier people who will live longer will choose the annuity, the pool of money will have to be stretched further among them, meaning less income per month for those that choose that, said Dr Kirchmaier.
"The price will go up, or, inversely, you will get less annuity,'' he said.Surprise
End Quote Barrie Cornes Panmure Gordon
"It was a surprise to the industry... I think that the annuity product isn't dead”
Annuity rates recently recovered to about 6% after hitting an all-time low in 2012 of about 5%, according to Which? That's still way below the average return from a pension pot at 65 of 15% in 1990, it said.
Companies which offer annuities appear also to be the initial loser.
Share prices for providers dropped sharply after the Budget speech. However, those in the industry, which saw sales of about £14bn in 2012, are putting a brave face on things.
Legal & General said today: "We expect pension savings, and hence the total pool of DC pension savings assets to grow.''
Partnership Assurance Group, a specialist annuity provider for people with health difficulties, saw shares fall 55% in London trading. But, it insisted that: "Partnership believes annuities remain an important part of retirement planning."
Some analysts said the damage done to stocks was to some extent a knee-jerk reaction.
"It was a surprise to the industry," Barrie Cornes, an analyst at Panmure Gordon, said. "I think that the annuity product isn't dead."