25 July 2014
Why lifetime annuities should still be part of good financial advice in the post-pension-liberalisation world.
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 (Whither UK Annuities?), published 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.
The research 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.
“Whither UK Annuities?” 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?
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.
Download a PDF of the report below.
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