A Remedy For Plunging Pensions

Published in Investing on 27 June 2012

Plummeting annuity rates are killing pensioners' incomes. Here's one way to fight back.

After, say, four decades of solid saving towards retirement, how do most pensioners part with their pension pots? Most use their funds to buy an annuity: an income for life paid by an insurance company to the 'annuitant'.

The awful world of annuities

I am no big fan of annuities, largely because of these three flaws:

1. When you buy an annuity, you surrender your cash pot to the provider. No matter when you die -- whether next week or in 40 years -- this lump sum is gone forever.

2. Too many pensioners buy their annuities from the firms with which they have saved. As a result, they buy uncompetitive annuities and lose out on thousands of pounds in extra retirement income.

3. Annuity rates are linked to the income paid by gilts (UK government bonds). As gilt yields have fallen to record lows, so too have annuity rates.

Male annuities set to slide

Furthermore, thanks to the European Court of Justice (ECJ), male annuity rates are set to fall even further.

In a bizarre illogical gender directive in March 2011, the ECJ ruled that, with effect from 21 December 2012, European insurers must not use gender-based factors when calculating insurance premiums. Therefore, from late 2012, men and women will be deemed to live identical lifespans -- even though, on average and in the real world, women live four more years than men.

This ruling will bring in lower annuities for men, who will be treated as if they live two years longer than they actually do. Similarly, annuities will rise for women, because two years will be lopped from their calculated lifespan. In other words, instead of dying at 78 and 82 on average, men and women will both be deemed to die at 80.

Consequently, the Association of British Insurers estimates that male annuity rates will fall by around 8%, while female rates will rise by 6%. However, as most pension assets are owned by men, there will be many more losers than winners.

To me, this unisex pricing for annuities (and life insurance, car insurance, etc) shows how ridiculously innumerate and out of touch ECJ judges are!

Down, down, deeper and down

The ultra-low rates on offer from today's annuities make them profoundly unattractive. Why buy a guaranteed income for life if it is guaranteed to be incredibly low -- and you lose your capital?

For example, 20 years ago, a pension pot of £100,000 would buy a 65-year-old man a level annuity of around £12,000 a year. That's an income of 12% of the sum surrendered. Thanks to collapsing gilt yields, the same pot buys a yearly annuity of around £5,850 at most (5.85%). Thus, in two decades, annuity rates have more than halved.

What's even worse is that there seems to be no end to this trend. In fact, in the past six weeks alone, annuity rates have fallen by roughly 5%, thanks to ever-lower gilt yields.

Two crucial steps for retirees

Sadly, things are set to get even tougher for would-be pensioners, thanks to the EU's Solvency II proposals. This regulatory change will force insurance companies and pension funds to hold more high-quality assets on their balance sheets. While making these firms more resilient to market shocks, Solvency II is expected to cut annuity rates by up to a fifth (20%).

Hence, with around 500,000 Brits retiring each year (rising to 850,000 a year), this annuity crisis threatens to become a national scandal as it pushes more and more pensioners into poverty. What can older Brits do to fight back in the battle for more retirement income?

One option is to shop around for higher annuity rates. You can do this by exercising your Open Market Option (OMO). This gives you a legal right to shop around and then buy an annuity from any provider you choose. Pensioners who don't exercise their OMO and, instead, buy their annuities from their pension providers could be losing out on an uplift of, say, a third (33%) to their retirement income.

Another option is to buy an 'impaired' or 'enhanced' annuity. These are available to adults with life-shortening medical problems (including stroke, cancer, heart disease, diabetes, high blood pressure and obesity) or poor lifestyle habits (such as smoking and drinking a lot).

Given that these folk can expect to live shorter lives after retiring, their annuity rates can be 30% or more above standard rates. Only one in seven annuities is impaired or enhanced, but more than half of retirees could take this option. Therefore, there is plenty of room for growth in this widely overlooked market.

Why buy an annuity at all?

Given that we're in the middle of a 'perfect storm' for annuities, my view is that now is not the time to lock into a low income for life.

Instead, I would 'up my risk' by looking to the stock market for an alternative to annuities, simply by buying the high-yielding shares of Britain's blue-chip giants. For example, take a look at the table below, which lists the 15 highest-yielding companies in the elite FTSE 100 (UKX) index:

CompanyMarket value (£bn)Price (p)PER*Dividend yield (%)Dividend cover
Resolution (LSE: RSL)2.7190.73.810.3%2.6
Aviva (LSE: AV)7.6264.415.49.9%0.7
RSA Insurance (LSE: RSA)3.7104.88.78.8%1.3
BAE Systems (LSE: BA)9.0278.06.16.8%2.4
AstraZeneca (LSE: AZN)34.92,794.05.96.5%2.6
Standard Life (LSE: SL)5.3224.617.16.2%0.9
ICAP (LSE: IAP)2.3340.79.06.1%1.8
National Grid (LSE: NG)23.6663.412.96.0%1.3
SSE (LSE: SSE)12.91,379.012.15.9%1.4
J Sainsbury (LSE: SBRY)5.5292.710.45.5%1.7
Vodafone Group (LSE: VOD)88.1179.412.05.3%1.6
Legal & General (LSE: LGEN)7.1122.29.75.3%1.9
Marks & Spencer (LSE: MKS)5.2318.09.25.3%2.1
British Land (LSE: BLND)4.5503.516.95.2%1.1
Royal Dutch Shell (LSE: RDSB)134.02,169.07.35.0%2.7
Average23.1 10.46.5%1.7
Minimum2.3 3.85.0%0.7
Maximum134.0 17.110.3%2.7

* Price-to-earnings ratio (how highly valued the market rates a company's earnings)

Source: Digital Look, 27/06/12

The first thing to note about this collection of high-yield shares is that the average dividend yield is 6.5% a year. This is above the 5-6% available from an annuity. In addition, as company earnings rise, this dividend yield should also rise over time.

Second, these dividends are mostly well covered, thanks to average dividend cover of 1.7 times earnings. Note that dividend cover is a mere 0.7 at insurance giant Aviva, but even a one-third cut to its dividend would leave these shares yielding 6.6% a year.

Third, on the whole, these shares are not expensive, trading as they do on an average price-to-earnings ratio of 10.4. This equates to an earnings yield of 9.6%, which already offers room for future dividend increases.

Fourth, all 15 are large, powerful firms. The smallest -- inter-dealer broker ICAP -- has a market value of £2.3 billion, while the Goliath is Royal Dutch Shell at £134 billion. Though the share prices of these big businesses will fluctuate over time, I fully expect their collective income to increase in the years ahead.

Fifth, it's important to note that I refer to this as a collection of shares, rather than a portfolio. That's because this is not a portfolio I would choose to build, largely because of its heavy concentration on the financial sector. Nevertheless, it is a start, because it provides some insight into the generous, blue-chip dividends on offer today.

(Ironically, five of these 15 shares are insurance companies, whose shares yield more than the annuity rates offered to these insurers' clients!)

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More from Cliff D'Arcy:

> Cliff does not own any of the shares mentioned in this article.

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Comments

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goodlifer 27 Jun 2012 , 7:35pm

It's important to take inflation into account.

You say, "20 years ago, a pension pot of £100,000 would buy a 65-year-old man a level annuity of around £12,000 a year".

If inflation's averaged 5%, and I had bought my annuity 20 years ago, my calculator tells me it would now be worth about £4300 per year of 1992's money..

But perhaps inflation's been conquered - along with boom and bust!

Vincent48 27 Jun 2012 , 8:26pm

>I am no big fan of annuities, largely because of these three flaws:

>1. When you buy an annuity, you surrender your cash pot to the >provider. No matter when you die -- whether next week or in 40 years -- >this lump sum is gone forever.

First mistake. Well, after this howler, I didn't bother reading any further.

How can people who pontificate on TMF still believe this? Do you really not understand that your "lump sum" is returned to you **as part of your pension?**

If you don't, then I guess you must think Repayment Mortgages are a real 'steal'. I had a repayment mortgage. Guess what? When it ended I never returned the amount I had originally borrowed.

Well I guess I that knocking at the door must be Nationwide coming looking for me.

OxonianCambion 27 Jun 2012 , 11:18pm

Don't forget that the fall to a tiny Gilt yield corresponds to a huge increase in value of Gilts already held.

Therefore people in a position to consider annuities will have benefited from a massive surge in value of their holdings (assuming they had a large allocation).

Personally, I see little point in an annuity. If I was in this position, I'd probably go the route of investment trusts (which will be able to give stable dividends).

Or just realise that total return is all that really matters and carefully work out a plan of selling lumps of shares off every so often, putting the proceeds into a low volatility OEIC, then selling bits of that off each month. (Obviously this would require active fiddling rather than the IT / HYP method above. :-) )

spinquark 28 Jun 2012 , 12:32am

Vincent, I think you are a little unkind.

Surely the point being made is that you no longer have any access to the capital sum which was used to purchase the annuity. Therefore should you have a critical need for a capital sum on top of the annuity income - for example to buy a life saving drug or operation, to pay unexpected legal costs, to support a partner or child through redundancy etc - you will have no possibility of doing this. Agreed spending from such a capital sum would create dire consequences for future income, but the immediate need could be even more dire.

I think goodlife hits it on the head. Inflation is the real enemy. Without a rising income you could be in penury within a decade of retiring on a comfortable income.

goodlifer 28 Jun 2012 , 10:19am

Vincent48
In a way you're quite right, but Cliff didn't really mean what he said.
People like journalists, salesmen and politicians often seem to find it difficult to say what they mean first time, even when what they're trying to say isn't all that difficult..
We just have to make allowances, and try and read their minds.



goodlifer 28 Jun 2012 , 10:25am

adolfslovechild
"Annuities are perfect for someonewho wants 100% guarantee of their income with no risk"

Presumably you're talking about index-linked annuities.....
Aren't they a bit pricey?.

Richard850 28 Jun 2012 , 12:24pm

Maybe I've missed something but how do you get your money out of your pension pot in order to invest in these shares? I have recently moved my pension pot to a SIPP and of course can now but individual shares - but the dividends will be reinvested and be added to the 'pot' i.e.still locked inside. How do I get the income when I come to retire apart from through drawdown?
Also I'm at least 10 years from retirement - anyone care to guess what annuity rates might look like then? I fear the worst...................

backdated 28 Jun 2012 , 12:44pm

Vince.

">1. When you buy an annuity, you surrender your cash pot to the >provider. No matter when you die -- whether next week or in 40 years -- >this lump sum is gone forever."

You don't think, through some slight miracle, that your money's given back to you over the rest of life (possibly any nominated dependent's life) then?

But keep repeating the mantra - it helps when the alternatives prove even more risky.


backdated 28 Jun 2012 , 12:49pm

Sorry Vince.

Just realised I took you completely out of context.

Ignore me.

I'm mad.

Most people do.

giveusaquid 28 Jun 2012 , 12:56pm

Confused me a bit there, was thinking the same about pensions - apart from the one off lump sum you normally get offered I thought you had to buy an annuity. But I think Cliff is referring to saving 'for' a pension rather than saving 'in' a pension. Still, does that really happen? People salt away their money for years, perhaps investing a little but when it comes to retirement they have a brain fart and in a sense 'give it all away' to an annuity?

Accumul8er 28 Jun 2012 , 2:40pm

Richard850
You are right that the way to get your money out of a pension pot is to use annual drawdown. However, the maximum drawdown is restricted to the amount of a level annuity.
Nevertheless, two factors may give better inflation protection than a conventional annuity. Firstly, the value of the underlying shares may rise over time (of course, they may also fall!). Secondly, the level annuity is reassessed periodically and as one gets older, the equivalent level annuity should rise with age (although other factors such as gilt yields, EU directives etc will also influance the revised rates).

adolfslovechild 28 Jun 2012 , 2:46pm

goodlifer,

No. I wasn't specifying the type of annuity, just generalising about the fact that the income is guaranteed, which to many people ( most people hate investment risk, and losing capital) so Annuity is the best option, unfortunately,

I don't think Cliff D'Arcy is giving a people a rational solution to annuities, with a headline grabber such as 'Remedy for plunging pensions'
I was simply trying to make a point, that purchasing shares is seriously risky, -and his article doesn't spell that out....

I guess it's a benefit of being a journalist, as opposed to a regulated adviser,- Journalists get a 'Free -shot' without any consequences.

goodlifer 28 Jun 2012 , 7:00pm

adolfslovechild

If anyone wants "100% guarantee of their income with no risk," doesn't that mean something index-linked?

Otherwise their income will be cruelly corrupted by the moth and rust of inflation

RetirementAngel 28 Jun 2012 , 7:06pm

It is true that when you buy an annuity then you cannot cash it in. In that sense the pot has gone forever. But, you do get a guaranteed income for life.

Now in our experience of advising 1000s of people at retirement, the one thing 90% of people get wrong is under estimating how long they will live. A woman aged 65 can generally expect to live beyond age 88 and a man to nearly 87.

Remember, that is just the average. A lot of people aged 65 now will live until they are 90+.

Try this App from Towers Watson a world leading firm of actuaries who collect the stats on longevity.

http://www.towerswatson.com/assets/downloads/mortality/default.asp?utm_source=APP&utm_medium=FB-TW&utm_campaign=TW-LifeTime

I agree that annuity rates will fall for men and that Solvency II might drop rates further. The Fool has though just picked up some figures from recent press and is too gloomy. My blog has more detail for those who are interested.

http://www.annuitydirect.co.uk/annuity-rates-the-future/

If you are going to stay invested, I would make sure you keep an
eye on what annuity you can buy. The chances are that it will make financial sense to buy an annuity before you are 75.

By investing in an annuity, you benefit from the funds of those who die early. If you aren't in the club then each year you lose that benefit. The benefit is worth less than 1% each year in investment return between ages 60-70 but builds up quickly to 2% per annum at 78 and gets to 4% per annum by is around 4% each year by age 83.

It is usually more expensive to invest in shares than in the bonds that an annuity invests in. So all told the investment route has a handicap which means it is harder to beat the annuity than the above article shows.

I have looked at £100,000 being invested 100% in shares and taking the same income from your assets as you could get from an annuity, £5800 per year for a man aged 65.

The range of possible outcomes at age 75 is very wide. Looking at 1000 simulations, the 50th best result is a pension of £19,500 and the worst 50th result is a pension of £2300. The mid forecast is £6900 which gives a nice little increase to offset inflation

The chance of beating the annuity at age 75 is around 60%.But because you have to review your income levels every three years, the chance that your income may have to be capped at below the annuity level is also around 60%

So if you can afford to take downside of losing more than half your pension then income drawdown could be a very good option for you.

A bit of balance could help. Take 50% of the shares out and replace with bonds and some cash and you find that the extremes move in.

You still have a 60% chance of beating the annuity with the mid forecast being £6400 and the best/worst 5% being £12,000 and £3500. The chance that the cap reduces your pension below £5800 before age 75 falls to around 50%.

The benefits of staying invested are therefore:

1. Protecting your pot if you die early
2. Giving you a chance to take a similar income from an annuity but with some reasonable prospect of seeing some increases to protect yourself against inflation.

Always look at the downside risk though, as I'm sure the Fool would agree, and make sure you don't gamble more of your income than you can afford.

max22222 03 Jul 2012 , 1:50pm

"Annuity rates are linked to the income paid by gilts (UK government bonds). As gilt yields have fallen to record lows, so too have annuity rates."

Gilts have risen by ~50% over the last 5 years. Reinvesting the income, as pension funds do, you would see another ~28% on top of that.

Low yields and annuity rates are merely a consequence of this boom.

Someone coming up to retirement will be better off than if they'd retired 5 years ago.

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