The past few months have seen many of the major Annuity providers reduce their rates, reducing the income your pension will provide.
We thought we would take a look at the reasons behind these rate drops and also consider where Annuity rates may go in the future.
The subject is complex, so bear with us, read on and we will try to provide answers as simply as possible.
So, why have rates dropped?
The major reason seems to be a significant fall in the yields of fixed interest assets (gilts and bonds) which are used to back Annuities.
|Average bank base rate since 1990||5.59%|
|Current bank base rate||0.50%|
|Average 15 year gilt rate since 1990||6.10%|
|Current 15 year gilt rate||3.51%|
On average how much greater is an annuity rate than the gilt yield?
If gilt yields increase to 5% what would the average annuity rate be?
The yields on fixed interest assets are impacted by the price they can be purchased for in the market place, which in turn is driven by simple supply and demand.
Supply and demand theory, to put it simply, states that the price of products, commodities, assets or services will be driven by how much there is of it in the market and how many people or institutions actually want to purchase it. This was illustrated rather well last week; there are only so many footballers with the skill of Wayne Rooney, when he indicated a desire to leave Manchester United the club were forced to pay more for his services.
With regard to fixed interest assets, the higher the price of these assets the lower yield. Therefore when such assets are in demand or are in limited supply then yields fall which in turn is bad for annuity rates.
Due to the unique economic conditions we currently live in, fixed interest assets are currently high in demand and limited in supply. Not good news for annuity rates!
Greater demand for fixed interest assets = higher prices = lower yields = lower Annuity rates
The three key drivers for this are:
1. Low Central Bank Interest Rates
In response to the global economic crisis, the vast majority of central banks in the Western economies have tried to stimulate growth by lowering their interest rates and encourage borrowing. Whether this policy has been successful or not, the fact remains that interest from cash is at an historic low. When cash rates are low, investors feel they are receiving a poor return and many will look for an alternative to secure better returns. Fixed interest holdings are often bought as an alternative and this increased demand raises prices, and lowers yields.
While interest rates remain low, the yields from fixed interest assets will be correspondingly low. When we see interest rates rise, the price of fixed interest assets should fall, thereby increasing the yield and pushing up Annuity rates.
2. Quantitative Easing (QE)
Another strategy used to promote borrowing has been the use of QE. The Bank of England printed extra money, £200bn to be exact, and then used this to purchase fixed interest securities, ultimately increasing the supply of money in the system. The fact that this extra money was used to buy fixed interest assets meant a corresponding increase in prices as demand increased and supply decreased.
This is the only time in history the UK Government has deployed QE, so we are in a unique position and this should not be forgotten. The Government will sell these assets in the future, increasing supply so we should hopefully see a drop in prices and an increase in yields.
3. Flight from Eurozone
The new Eurozone crises has been a triple whammy for our rates as confidence in Sovereign debt has dwindled and investors have moved in to non-Eurozone government bonds, including the UK.
We were seeing a degree of recovery in yields in early 2010. For example, the 15 year gilt yields went from 3.75% in October 2009 up to 4.5% in March, but once again, demand for UK fixed interest was on the up so yields went down again.
In addition to yields falling, the EU Solvency II directive must be considered. The directive essentially alters the type of assets that can be used to back an Annuity, reducing the level of risk that providers can take. There is evidence that providers are slowly factoring Solvency II into their pricing. For example Prudential’s Head of Business Development for pensions, Vince Smith-Hughes, told a recent industry conference: “Providers are already pricing in Solvency II. We certainly are, so we will see rates gradually decrease.”
He continued, “Most people think it will be around the 10 per cent mark but this is in the context of having the lowest annuity rates ever, so we know it will mean they are not particularly great value, if indeed they are great value at the moment.”
In the midst of falling Annuity rates there is the odd provider occasionally increasing their rates. Aviva, for example, increased their rates recently, at the same time however other providers such as Canada Life and Living Time reduced rates.
Where will Annuity rates go in the future?
Unfortunately, we do not have a crystal ball, however when all the evidence is weighed up it would be fair to say that more reasons exist to think Annuity rates may remain static or even fall, than rise, especially in the short term.
The case for Annuity rates remaining stable or indeed falling:
- If interest rates stay low, fixed interest assets will continue to be desirable, causing supply and demand issues and keeping yields suppressed. Despite the odd dissenting voice, the Bank of England’s Monetary Policy Committee (MPC) are showing little desire to increase interest rates
- The past couple of months have seen more people talking about the possibility of a second tranche of QE. If this was to happen, and the original pattern was repeated with the buying up of fixed interest assets, we would obviously see demand for such assets increase. We all know what this means for yields and Annuity rates
- Recent moves by the Government to address the UK’s financial deficit seem to have gone down well with the City, reassuring investors about the UK’s credit worthiness, thereby increasing demand for UK Gilts and again reducing yields
- There are only a small number of Annuity providers in the UK who are seriously competing in the market. This reduces the need for providers to offer better rates
Is there any upward pressure on Annuity rates? Well, there is nothing definite about a second round of QE indeed the latest growth figures probably make it less likely. Interest rates could rise if the economy recovers more quickly than anticipated and especially if inflation remains above the MPC’s target. The theory is of course that higher interest rates mean less demand for fixed interest assets thereby reducing the price and increasing the yield.
I am thinking about buying an Annuity now, should I delay?
This really is the $64,000 dollar question, and unfortunately not one easily answered.
Anything that pushes up the price of fixed interest assets will reduce the yield and therefore Annuity rates, unfortunately we seem to be living in a time when this is exactly what is happening.
If you want to retire now you will naturally need income, the question is how to create this from your pension fund.
If you feel that Annuity rates will remain relatively stable or even fall you could simply plough on, purchase a Lifetime Annuity now and forget about it. This option has the benefit of certainty and simplicity; furthermore it would probably be true to say that there are more economic indicators suggesting a fall in Annuity rates than a rise.
However, you could take the view that we are in unprecedented times, QE has never been tried in the UK before, and interest rates are at historically low levels as are gilt yields, therefore why lock into a Lifetime Annuity in these uncertain times?
If you subscribe to this view but still require an income, you may benefit from an alternative product, which will meet your income needs now but not tie you in to a Lifetime Annuity leaving you stranded should rates rise. Such alternatives include a Fixed Term Annuity or Income Drawdown, both come with advantages and disadvantages, which are well covered in other areas of this site. Essentially this option puts you in a “holding position” until more economic clarity emerges; of course clarity does not necessarily mean higher Annuity rates.
One thing is for certain, picking the time when you buy an Annuity has never been simple; today’s economic climate does nothing to help make the decision easier. However, our team is here to help guide you through the options you have and arrive at a solution which meets your needs both now and in the future.