Annuity meltdown will eventually end

If you're younger than 55, you don't need to worry too much about the annuity meltdown. Rates should recover eventually. But it's a different story if you're older.

I was down the pub last week with some lovemoney.com colleagues and the conversation turned to pensions.

Both colleagues had reviewed their pensions recently and they were shocked to see how small an income they’d get if they were retiring in 2012.

Low, low rates

I can understand why they were shocked. Many new retirees are getting very disappointing pensions because annuity rates have fallen to such low levels.  In fact, data from MGM Advantage shows that annuity rates have fallen by 14% since June 2009 and by around 2% since March 2012.

(For an explanation of how annuities work, read Become a pensions expert in five days:  the lowdown on annuities).

So if you’re a 65 year-old single man with a £50,000 pension pot, you’d only get an income of £3,129 a year if you bought a conventional annuity today*. Back in 2009, a 65-year old man would have got £3,638 a year, and he would have got far more ten or twenty years ago.

Even worse, I fear that annuity rates are going to fall even further over the next two or three years, which is terrible news if you’re approaching retirement. There are two main reasons for this:

1. EU ruling on gender discrimination

By the end of the year, the EU won’t allow annuity providers to pay bigger annuities to men – even though men typically live shorter lives than women. In theory, male annuities should fall while female annuities rise, but the expectation is that male annuities will fall and female annuities will barely move.

2. Solvency 2

Solvency 2 is another EU ruling that will force annuity providers to take less risk with their portfolios. This will also drive down annuity rates.

And, of course, life expectancy will continue to rise too.

Good news

However, I’m more positive when I look at the long-term picture. Even though I expect annuity rates to fall over the next two or three years, I do think they’ll eventually start to rise again. And if you’re not going to retire for at least another ten years, you’ll probably be able to get a better annuity than people retiring in 2012.

It’s all connected to the price of UK government bonds or gilts. These bonds are basically IOUs issued by the British government and they’re normally regarded as very safe investments.

When you buy an annuity, your annuity provider will use your pension pot to buy gilts and then use the income from the gilts to pay you a pension. (Read more in Why gilts matter.)

So if gilts are expensive, they produce a small income relative to the price, and annuity providers will only be able to pay a low income to new retirees.

That’s been the case in recent years and the high price of gilts has triggered a meltdown in annuity rates.

There are four main reasons for the rise in gilt prices:

• Financial markets are expecting the UK economy to be sluggish for years to come and the markets also expect low inflation. In that kind of environment, gilts are attractive.
• Following the financial crash, international investors have been looking for safe homes for their cash. Stable countries with their own currencies are seen as safe, and the UK ticks both those boxes. So gilts have been very popular.
• The Bank of England has been using the money it’s created via Quantitative Easing (QE) to buy gilts. So there’s been more demand which has pushed up the price.
• Regulators believe that pension funds have historically been over-exposed to traditionally risky investments such as shares, so the regulators have pushed funds to invest more in gilts and other lower risk assets.

Things will change

As I said, I’m confident that annuity rates will eventually start to rise and that’s because I expect gilt prices to fall at some point in the next few years. 

For starters, the Bank of England can’t carry on creating new money forever, and when Quantitative Easing stops, there will be less demand for gilts. 

And more importantly, gilt yields are just astonishingly low. As I write, the yield on 10-year gilts is just 1.44%! In other words, if you bought a gilt that was due to expire in ten years’ time, you’d only receive a return of 1.44% a year.  You’d do far better in one of the best instant access savings accounts. 

That kind of yield only makes sense if:

• you expect inflation to fall further and then stay low for the next decade 

and 

• you expect economic growth to stay low for at least a decade 

and 

• you think investors will carry on being desperate for assets that are traditionally seen as low risk.

In fairness, I think there’s a strong chance that our economy will stay sluggish for years to come and that inflation will stay low too. But, for me, a 1.44% yield more than reflects that outlook. And anyway, we will eventually recover from the 2008 financial crisis. When that happens, gilt prices will fall, annuity rates will rise, and new retirees will get a better deal.

That’s great news for someone like me who is only 44. But for anyone over the age of 55, it’s harder to be so sanguine.

If you’re in the latter situation, it may make sense to buy a short-term annuity when you first retire. Then you’ll be hopefully be able to benefit later when annuity rates finally go up. Or you could delay your retirement. Find out more in How to combat falling annuity rates and Why your retirement just got better.

*This is a level annuity for a single man. There are no guarantees. In other words, the 65 year-old man will receive £3,129 a year until he dies. The sum will never increase and payments will cease as soon as he dies.

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