Articles - Annuities, are they value for money?

I recently contacted a few leading annuity advisers to test the concept of disability-linked annuities as an option for helping to fund future care. In other words, in exchange for an annuity that would increase if care is required later in life, would their customers be prepared to accept a reduction in income at outset of around 5 – 10% to pay for this option.

 By Tim Gosden, Head of Strategy for Legal & General’s individual annuity business

 The response was muted because, not surprisingly, maximising income at outset is still key for many consumers. However one leading IFA made an interesting comment:

 “The big issue is that annuities are just not good value. We are doing a lot more drawdown/invested business because customers are starting to question the value for money of annuities and are prepared to take more risk”.

 So in this month’s issue we put this comment to the test.

 What’s on offer?

 To start, a good source for comparing annuity incomes is the Money Advice Service (MAS) website and their annuity and pensions comparison tables. These popular online tables enable comparisons of the annuities offered from the most competitive providers on a real time basis. Standard annuities are offered by six providers including Legal & General, Prudential, Aviva, Canada Life, Saga and Hodge Life There is also scope to include lifestyle type information including smoking, body mass, high blood pressure/cholesterol to assess qualification for an enhanced annuity.

 In 2012 the overall average pension pot used to purchase an annuity was £33,000. So to provide a broad view, below is a comparison of ‘standard’ annual annuity incomes for a 65 year old with fund of £25,000, £50,000 and £100,000*:

          Lowest     Average     Best     
     best and
    £25,000     £1,334     £1,403     £1,482     £148
    £50,000     £2,686     £2,851     £3,004     £318
    £100,000     £5,269     £5,643     £6,044     £775

 *Source: Money Advice Service Tables July 2013, single life, level, no guarantee, paid monthly in advance, mid range postcode.

 The difference between the best and the worst incomes may not seem a lot but the annuity income is guaranteed for life and so the overall return should be considered in terms of the lifetime income. 

 According to the latest Office for National Statistics, (ONS) figures for life expectancy** a male currently aged 65 could on average live for an additional 18.2 years, so lets say to age 83 and a female 20.8 years, to age 86.

 So using the more conservative male assumption, the lifetime income paid over 18.2 years would be as follows:

     best and
    £25,000     £24,278     £25,534     £26,972     £2,694
    £50,000     £48,885     £51,888     £54,672     £5,787
    £100,000     £96,895     £102,702     £110,000     £14,105

 First and more foremost, the difference in lifetime income illustrates the real benefit of shopping around using the Open Market Option (OMO). Lets also not forget that these incomes are based on figures provided by the more competitive annuity providers.

 However, an astute customer may look at these returns and view an annuity as a poor investment. For example, investing £25,000 to generate the best annuity of £1,482 in a bank deposit account would require interest of just 0.78% to avoid the fund running out before age 83. There is also the issue that four in 10 retirees and pre-retirees underestimate their life expectancy by five or more years*** and so perhaps it is not surprising that annuities are seen in such a poor light.

 Life expectancy for the OMO population

 So we need to dig deeper. ONS life expectancy statistics look at the population as a whole, whereas annuity providers take a very different view of the life expectancy of customers who exercise the OMO. These customers are a subset of the population and based on experience of this particular market, which takes account of many factors, annuity providers will view these customers as being in better health than the average population. For example, Legal & General estimates that a 65-year-old male will live for 25.1 years in retirement, so to age 90 rather than the ONS prediction of 83.

 Taking this into account then investing £25,000 in a bank deposit account would now require an interest rate of 3.61% to generate the best income of £1,482 and avoid depletion of the fund before age 90. Similarly, for the £50,000 fund and £100,000 fund the minimum interest rate required is 3.75% and 3.81% respectively to match the best annuity income and avoid depletion.

 Insurance against the risk of living too long!

 So to appreciate the value of annuities requires an understanding of life expectancy but there is also the issue of cross subsidy and the pooling of risk concept on which annuities are based. Not everyone will live as long as predicted and the funds of those who die earlier than expected are used to subsidise those who live longer, which to some customers may appear unfair.

 For our 65 year old, another way of looking at this is to invest £50,000 in a bank deposit account, where on death any remaining funds would still be available to the estate. Assuming an average interest rate of 2.5%, and that capital and interest is used to draw an income on a monthly basis that is equal to the best annuity income of £3,004pa, the bank deposit account would be depleted at age 87. However, the annuity would continue to provide a guaranteed income for life and as mentioned previously we would expect a significant proportion of individuals retiring today to live beyond 87.

 So it is important for consumers to understand that that the key issue for them is not so much reaching age 87 but being in their early eighties with the prospect of their income running out and potentially leaving them destitute. This is where the pension annuity delivers true value to consumers because it is the annuity provider that not only takes on the investment responsibility and risk but also the risk of providing an income for the life of their annuity customers.

 To summarise, we don’t know how long we are going to live, but one thing is certain, we are all living longer. Put simply the pension annuity should be seen more as insurance against living longer than expected rather than an investment. It delivers the benefits that most people want from a retirement income; simplicity, security and a guaranteed income stream, no matter how long they live – and that has to be good value!

 Tim’s Retirement Quiz

 Which two of the following locations are classified as ‘Blue Zones’ where people live longer and healthier lives than anywhere else on earth?

 1. Interlaken, Switzerland
 2. Okinawa, Japan
 3. Tromso, Norway
 4. Byron Bay, Australia
 5. Silanus, Sardinia
 6. Itacare, Brazil
 7. Shangri-La Valley, Panama


 Highlight white text below to view answer:

 2. Okinawa and 5. Silanus

 ** ONS Interim Life tables, England and Wales, 2009 – 2011
 *** Research by the Society of Actuaries, July 2012

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