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:
|Company||Market value (£bn)||Price (p)||PER*||Dividend yield (%)||Dividend cover|
|Resolution (LSE: RSL)||2.7||190.7||3.8||10.3%||2.6|
|Aviva (LSE: AV)||7.6||264.4||15.4||9.9%||0.7|
|RSA Insurance (LSE: RSA)||3.7||104.8||8.7||8.8%||1.3|
|BAE Systems (LSE: BA)||9.0||278.0||6.1||6.8%||2.4|
|AstraZeneca (LSE: AZN)||34.9||2,794.0||5.9||6.5%||2.6|
|Standard Life (LSE: SL)||5.3||224.6||17.1||6.2%||0.9|
|ICAP (LSE: IAP)||2.3||340.7||9.0||6.1%||1.8|
|National Grid (LSE: NG)||23.6||663.4||12.9||6.0%||1.3|
|SSE (LSE: SSE)||12.9||1,379.0||12.1||5.9%||1.4|
|J Sainsbury (LSE: SBRY)||5.5||292.7||10.4||5.5%||1.7|
|Vodafone Group (LSE: VOD)||88.1||179.4||12.0||5.3%||1.6|
|Legal & General (LSE: LGEN)||7.1||122.2||9.7||5.3%||1.9|
|Marks & Spencer (LSE: MKS)||5.2||318.0||9.2||5.3%||2.1|
|British Land (LSE: BLND)||4.5||503.5||16.9||5.2%||1.1|
|Royal Dutch Shell (LSE: RDSB)||134.0||2,169.0||7.3||5.0%||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.