Current market conditions are not ideal as gilt yields and equity markets are at lows. However, analysts warn rates could still fall further and recommend buying now rather than later
The current low annuity rates leave many pensioners with little choice but to buy a product with lacklustre returns compared to those available in the past.
It is an issue that has been around for several years. When income drawdown products came out in the mid 1990s one of the marketing arguments was that these offered investors the opportunity to defer annuity purchase until such time as rates improved.
Since then rates have fallen further and there is little hope of improvement in sight.
If spending £100,000, the highest annual rate a 65-year old male looking for a single life annuity can currently obtain is 8.14%, from Prudential, while at 70 the maximum is 9.18% and at 74 the maximum is 11.80% both from AMP NPI.
There are two main reasons for low annuity rates. The first is because people are living longer, it is necessary to adjust annual payout rates to a lower level to accommodate for the fact that income is likely to be paid for a greater number of years.
The second is that annuities are usually backed by gilts. As gilt yields have fallen, due to low interest rates and inflation, so too have the rates available on annuities.
John V Morgan, marketing director for retirement products at Legal & General feels annuities come in for unfair criticism.
'Interest rates are generally lower, which is reflecting the outlook for inflation and we are in an era of lower inflation. Therefore the real purchasing power of money does not diminish as quickly as it once used to,' Morgan says.
Paul Tinslay, head of pensions at Towry Law, believes that as long as inflation remains low, then annuitants should maintain their spending power.
'Obviously the ideal situation is to have bought an annuity about 15 years ago when interest rates and inflation were high, and then to have seen interest rates and inflation fall since so you have locked into high rates but maintained spending power,' he adds.
'The worst situation is to buy your annuity when interest rates and inflation are fairly low, and then see interest rates and inflation take off.'
It may be tempting for some potential annuity buyers to hold off buying in the hope of capturing better returns in the future. This, however, is a high-risk game given there are no strong signs that rates are likely to improve.
David Marlow, marketing manager at the Annuity Bureau, says: 'The gilt yield has been falling for some time, causing annuity providers to cut the incomes they pay. Given that we are expecting the Bank of England to cut interest rates by another 25 basis points at some point in the near future, this could influence rates and lead them to fall even further.
'So the message is that the direction of annuity rates is not predictable. We don't try to advise our customers when would be the right time to buy an annuity as it is very difficult to have a suitable forecast for the future. I would say that you are better off buying now than later, as there is still room for rates to get worse.'
Although the low inflation and maintaining real spending power argument does hold water for Marlow, he believes the problem is that there is no guarantee that low inflation is here to stay.
'If inflation is maintained at a low level throughout your lifetime, then low rates are far less of an issue. There can be no guarantee that this would be the case. So there is the concern that you are buying at a low point in the annuity market place and at some point in the future you might experience high inflation,' Marlow says.
'The problem is what to do about that. If you defer taking your annuity income, then you could suffer from a reduction in the capital value of your pension fund. Of course, interest rates and annuities could worsen even further, so you would be taking a substantial risk by deferring at the moment.'
Tinslay adds that if investors hold off from buying an annuity for too long, and therefore are not taking the income, then they could start to suffer from the cost of deferral.
Hence, if a single man at 65 can buy a £100,000 annuity on a rate of 7%, this would buy income of £7,000 per year. If the same person waits until they are 66, and the annuity rate does not change, but the £100,000 has gained 10% and is now worth £110,000, then the annuity will buy an income of £7,700.
Because that person lost the £7,000 that they didn't take in the previous year, it takes a significant amount of time to catch up, even with the higher invested amount.
One way life companies are getting around the low yields on gilts is by backing a proportion of their liabilities with investment grade corporate bonds. This has become increasingly popular over the past three to four years, due to the lack of gilt supply.
The proportion of corporate bonds held by life companies can vary. Tinslay says, for example, there has been circumstances in the past whereby Prudential and Canada life have been almost fully invested in corporate bonds.
'It depends on the supply and demand. If there is a particular stage where gilts are not being traded and there are no new issues, then they are more likely to hold corporate bonds,' he says.
Corporate bonds are also attractive, particularly for financially secure companies like Prudential, as they can be a more attractive option than gilts due to their higher yields.
While the yield on corporate bonds is higher than gilts, this is only the case because these are not considered as safe as the Government paper. Although there is a higher risk/reward ratio with corporate bonds, Tinslay does not believe life companies are being complacent with annuitants' money.
Even so he thinks it is necessary to do homework on the financial security of the annuity being chosen for a client.
He adds: 'Whereas in the past you have had annuities backed by gilts, the likelihood of problems has been relatively small. From my own experience I have found that 99% of the reason for buying any annuity is due to the rate offered, and only around 1% is because of the company's financial security.
'Now that corporate bonds are being increasingly used, the financial security aspect of a company has become more important. Therefore, when providing advice, it is vital to take the financial security of the annuity provider into consideration.'
Marlow thinks there is no reason to be alarmed by the emergence of corporates as an asset class backing annuities.
He says: 'Groups are increasingly using corporate bonds but this is not a concern. The solvency margins required should be sufficient to safeguard any defaults that providers may experience on their corporate bonds. So in reality it is very good news as it provides a way for life companies to pay as much as possible to annuitants that are retiring now.
'Furthermore, I wouldn't expect them to be using the higher risk junk bonds in any way and I expect that the default rate on the investment grade corporate bonds would be very low. Policyholders should not be concerned as there are still sufficient safeguards to make sure they will receive their guaranteed income.'
Falling gilt yields and interest rates reduce income available from conventional annuities.
Low inflation means annuitants retain spending power.
Deferring annuity purchase a high risk game as rates could fall further.
Deferring annuity purchase means loss of income.
Life offices using more corporate bonds to back annuities.
Need to look at financial security of life office which uses corporates to back annuity book.
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