It is eight weeks since the United Kingdom’s new pension freedoms came into force. It is all rather wonderful.
Unless that is, you have already retired and have bought an annuity.
Before April this year, it was possible to keep your money invested and draw it down bit by bit. But the amount you could take was subject to a cap and anything left over was hit with a 55 per cent “death tax.” So the majority of people simply turned their pension fund over to one or other of the insurance companies on retirement, in exchange for a guaranteed income for life—an annuity.
These have never been wildly popular. The insurance companies have devoted a stunning level of effort over the years to ensuring that almost no one gets value out of them and they die with you regardless of how quickly you pop your clogs after taking one out—that’s maddening for the families of those who have saved early and often but died prematurely. However since the financial crisis annuities have become one of the most loathed products in the market. Why? It’s all about super low interest rates. The income you can get in exchange for your pension lump sum is based on the yield on long dated gilts (UK government bonds) so the lower that goes, the less you get. Right now yields are at multi-decade lows and annuity rates are pathetic. Retire at 65 in perfect health and ask for an inflation linked annuity and you’ll be lucky to be get £4,000 per £100,000 you hand over (4 per cent). You could, say irritable annuity holders, get the same yield in the stock market without taking too much risk and get to keep the capital too. It just isn’t fair.
Look at it like that and it isn’t. Why should pension freedom give new retirees the right to manage their own money as they like but keep older retirees locked into an antiquated and deeply unsatisfactory annuity system? Luckily the over-65s are not a generation to keep their gripes to themselves and the outcry over this perceived injustice has been intense enough for the government to announce that it intends to put in place a system that allows annuity holders to sell their products on the open market.
It’s exciting stuff. And you can see the temptations—who wouldn’t want to swap a small income for a much larger lump sum and (crucially) the right to pass that lump sum to their children?
But it is hard to see how it can work. There will be plenty of sellers out there. But who will be the buyers? And how will the price be set? When you buy an annuity you get a better deal if you are in poor health. But when you are selling one (which dies with you) being in poor health isn’t much of a selling point, as the annuity only pays out if the holder is alive. That means that those most likely to want to sell will be those with the least attractive product: unless they can somehow prove that their 40 years as a smoker have made no difference to their health, the price can only disappoint them.
That’s particularly the case given that if there are any buyers in the market they will be the same insurers who sold pensioners the annuities in the first place—they offered bad deals on the way in, why would they offer good ones to the ill or the desperate on the way out?
Over all the initial signs are that if a second-hand annuity market were to develop, most of those who sold would end up with less than they would have been paid in total had they held on. There’s a mis-selling scandal in the making for you. But it isn’t just exploitative insurance companies we need to worry about. There are family dynamics too. How much pressure might the old come under to trade income for lump sum from families in want of house deposits and inheritances? That’s worth worrying about, too.
Finally it is worth noting that annuities aren’t all bad. Pension freedom comes with risks. Some people may spend their money too fast, ending up with no income at all inside an unsympathetic welfare system. And some might go for what the industry is calling “reckless prudence”: fretting so much about not having enough that they live an unnecessarily frugal and miserable life in their retirements.
These people should have annuities, or should at least buy annuities with a part of their retirement funds. It might look like an odd choice given the freedom options but a stable and guaranteed income can bring a lot of joy to a life; it’s also something that most research shows retirees really want. Most of those who have one already shouldn’t sell. And, given that pension freedom is going to force the annuity providers to up their game with new products (return of your capital guaranteed, for example) a good percentage of those who are soon to retire should at least think about buying.