97% of the fall in annuity rates down to increased longevity and low investment returns
Many lifetime annuities offer fair value for money according to new research by Jonquil Lowe of the True Potential Centre for the Public Understanding of Finance at The Open University Business School.
The report, which has been published today by the International Longevity Centre UK (ILC-UK) also argues that the protection against longevity risk may be poorly understood by consumers.
Falls in annuity rates over the past 25 years mean that an individual who wanted to start retirement with a nominal income of £10,000 would have needed a pension pot of £65,000 in 1990 but over £175,000 by 2013. This has led to a commonly held view that annuities are a bad investment, which overlooks the insurance value of annuities, particularly in the face of increasing longevity.
The research confirms that the major determinants of annuity rates are life expectancy and long-term interest rates. A simple linear regression of UK level annuity rates for a 65-year-old man against a benchmark 15-year gilt rate and cohort life expectancy using monthly data over the period 1991 to 2013 explains 97 per cent of the variation in the annuity rate.
The research considers whether annuity rates can be considered actuarially fair (i.e. if the expected discounted present value (EDPV) of the income equals the price paid).
Lowe finds that some annuity consumers are getting more than value for money (Money Worth Ratio (MWR) of more than 1). For most people buying the best value annuities (average of the top three rates), the MWR at all ages for women and at ages 55 to 70 for men is greater than 0.85. This is within the usual range for MWR therefore does not suggest an excessive mark-up by providers.
Even the worst annuity rates generally deliver value for money to women, with the exception of those with standard life expectancy aged 75. The worst annuity rates offer poor value for money to men however; the exceptions being men with higher-than-average life expectancy aged 55 or 60.
The results suggest consumer detriment to those male annuity purchasers who end up on the worst rates, but otherwise a product that is generally delivering value for money.
Lowe argues that annuities should be viewed through a consumption frame, focusing on what can be spent throughout the remaining life course, suggesting that if advisers and individuals are using an investment frame, the focus will be on rate of return and investment risk, but not longevity risk.
The report sets out the implications of this research for pre-retirement guidance and advice
- Guidance or advice must help consumers understand the nature of longevity risk and how to protect against it
- Guidance may be needed more than once given increasingly flexible retirements, and the fact that individuals will be free to draw their pension savings in as many tranches as they choose
- Should government go further and mandate advice for DC members who are contemplating giving up aspects of their retirement security? Is there an inconsistency given those on DB schemes who wish to transfer to DC schemes from April 2015 will need to take advice?
- Will guidance be sufficient? Guidance is non-specific; does not advocate a particular course of action; and does not recommend the purchase, sale or alteration of particular regulated products from particular providers. It seems likely that many, if not most, individuals approaching retirement would need to be directed to an authorised financial adviser for regulated advice, which begs the question whether guidance has a role at all beyond signposting to sources of authorised advice?
Author of the report and lecturer in Personal Finance at The Open University, Jonquil Lowe said: “This much maligned financial product should ideally still play a key role in most people’s retirement planning and in the free, impartial guidance for every retiree promised as part of the government’s pension liberalisation package. A fall in annuity rates associated with increasing life expectancy does not equate to a fall in value for money ; rather it represents a spreading of value over a longer period.”
David Sinclair, Director, International Longevity Centre – UK (ILC-UK) added: “The research dispels the argument that consumers should automatically shun annuities on the basis of value for money. But given the gap between the best and worst annuities in terms of value for money, it is vital that we continue to encourage and support retirees to shop around in order to get the best value annuities.”
The report points out that annuities may not be the right option for everyone. Other strategies and products may be more suitable for those with higher risk tolerance, greater resources and/or a desire to leave bequests. Those with low resources who can expect a high proportion of their income to come from their state pension and those with debts may still prefer to forego a pension income for a lump sum.
In its 2014 Budget, the UK government announced that from April 2015 its citizens entering retirement will no longer be steered towards using their tax-advantaged pension savings to buy a lifetime annuity (a financial product where a lump sum is exchanged for an income for life), or indeed to securing an income at all. Instead retirees will have complete freedom to draw out their savings whenever and however they like, provided they have reached at least age 55.
*If the EDPV equals the price paid then its ratio to price will be 1. This ratio is commonly called the Money Worth Ratio (MWR) and is a standard way of evaluating annuities. In practice, the ratio will normally be less than 1 since the insurer incurs costs including normal profit. If there is a lack of effective competition, the insurer might also be making supernormal profit, in which case the MWR could be substantially less than 1.
The International Longevity Centre-UK is the leading think tank on longevity and demographic change. It is an independent, non-partisan think tank dedicated to addressing issues of longevity, ageing and population change. We develop ideas, undertake research and create a forum for debate.
The Open University Business School (OUBS) is a leader in modern flexible learning and the pioneer of teaching methods that enable people to change their life goals, studying at times and in places convenient to them. The OUBS is one of a select group of schools worldwide accredited by the three leading international accrediting bodies – AACSB, AMBA, EQUIS – hallmarks of quality of teaching, learning materials and qualification impact. It is the only triple-accredited business school that specialises in flexible learning and is home to more than 24,000 MBA graduates in over 100 countries. Its MBA programme offers both residential schools and face-to-face and collaborative learning options.
For more information, please see its website at www.open.ac.uk/business-school
The True Potential Centre for the Public Understanding of Finance (PUFin) is a pioneering centre of excellence for research and teaching related to personal finance capability. Based at The Open University Business School, PUFin is generously supported by True Potential LLP.
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