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David Ferguson: Awkward questions required on annuity pricing


I found myself immersed in an interesting twitter discussion yesterday with a number of pension experts regarding annuities, and more specifically whether or not annuities represent value for money.

I had a bit of a busy afternoon/evening but when I got up this morning I did some quick research.

Firstly I pretended I was 22 years older than I actually am (making me a male aged 65) and then assumed I had a pension fund of £100,000. There are many ways in which one could derive a retirement income from this money and they come with various combinations of guarantees, lock-ins, flexibility etc.

However, because it was early in the morning and I frankly couldn’t be bothered considering all of the alternatives (and in the interests of keeping this simple) I looked at just two scenarios:

1. Purchase an annuity from Aviva (chosen simply because one of the twitter-ers works for them – a couple of experts advise me that other company’s rates are similar enough to make this post valid)

Aviva’s (quite cool) online quick quote tool advised that I could receive an income of £5534.88 per annum for life and that if I pre-deceased my darling, magical wife, she would receive 50 per cent of this amount until she died (she was assumed to be two years younger, which isn’t true but nor does it really matter here). In the event that we both die, the retirement income would cease.

2. Purchase the Aviva 6.125 per cent 2036 corporate bond

The LSE website confirmed that I could invest £100,000 in the Aviva 6.125 per cent 2036 corporate bond at a price of around 99.28. To keep the arithmetic simple, let’s pretend that the price was actually higher and was 100.00, which should also allow me to ignore the dealing charge.

In this scenario and providing Aviva doesn’t default I can receive £6,125 for each of the next 23 years and then have my £100,000 returned to me. If I die in the meantime my investment will have a market value which could be nil (if Aviva is in default) or might more likely be a lot, lot more.

So, it’s decision time. Would you choose (1) or (2)?

As stated in the intro there are a lot of factors to consider but I can’t help thinking most people would rather receive 10.6 per cent more each year, run the risk of Aviva defaulting and in all probability ensure a far higher sum passes to their estate on death.

In any event, in the extremely unlikely event that Aviva was to default, what are the chances of the annuitants continuing to receive their income?

This is obviously not a true ‘apples for apples’ comparison but somewhere in these numbers lies the true value of an annuity and it gives some clues to how the market functions. I wonder how many fully informed people are (a) truly able to quantify this value and (b) would choose to buy an annuity from Aviva over the Aviva corporate bond?

Finally, some small print:

1. Holding the bond on the Nucleus wrap would mean paying around £350 per annum in platform charges. If this was the only asset in someone’s Sipp there is probably a cheaper way to hold the bond.
2. I know that annuities are backed by assets other than corporate bonds (eg gilts).
3. I also know that if I was 65 and unhealthy, a smoker etc I could secure a better annuity rate but that is not because annuity providers are charitable, it is because they expect to pay me less before I die. If I pay more for life assurance, the converse is only reasonable.
4. I am also aware that this scenario might not be possible due to drawdown constraints. These technical points don’t however amount to a credible defence of annuity pricing. At least not to me.

David Ferguson is chief executive at Nucleus



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There are 29 comments at the moment, we would love to hear your opinion too.

  1. Good one. looking forward to other comments.

  2. Not Nick van Hoogstraten 20th August 2013 at 2:22 pm

    Or Aviva could invest it in some nice rented flats and get a rental of 6.0 – 6.5% p.a which could be enhanced by gradually being run down in the manner of an annuity – think of it as someone else buying you our of the asset on an HP basis so that by the statistical end of life time they’ve bought the whole thing.
    Annuities are close to being a complete rip off- not so much because the annuity provider is a crook, but the yield on Gilts is laughable thanks to the Bank of England and their QE programmme. It is perfectly possible to get as much safelty and much better yields, so why don’t annuity providers do so?

  3. Anyone who would trust their entire retirement income to a single company is an idiot. Cautionary tale in the Money section of the Sunday Telegraph, 250 online comments all containing the words “no sympathy”, weapons-grade idiot. The fact that Aviva is a big company is irrelevant – Lehman Brothers, Equitable Life, Enron etc etc etc.

    “In any event, in the extremely unlikely event that Aviva was to default, what are the chances of the annuitants continuing to receive their income?”

    They take a 10% haircut but otherwise still get their income courtesy of the Financial Services Compensation Scheme. Infinitely better than nothing.

    I like a thought exercise as much of the next man, but sorry, this is a meaningless comparison.

  4. @Not Nick: What do you do when the flats are void? Stop paying the annuities? Keep a reserve, I assume you’ll say. But it’s difficult to know how much to keep, especially given that market conditions in something like residential property can be very volatile. If the rental market rockets and suddenly the annuity provider is coining in far more than the agreed annuity rates, do they put it all in reserve? Pocket it? Or give some to the annuitants?

    Very difficult questions and full of pitfalls, which is why if someone takes out a non-with-profits annuity which is guaranteed for the rest of their life (which could be anything up to 50 years), you back it with gilts to match the liability.

  5. By the way (and apologies for hogging the thread), if Ferguson’s option 2 still sounds attractive to anyone, can I suggest option 3: bet your entire pension fund on Bayern Munich winning the German football league, and then buy the Aviva corporate bond. Ignoring pricing changes up to the end of the season (and you can always substitute whatever is equally attractive in one year’s time), that’ll get you a 20% uplift in income, plus the 10.6% uplift from the bond.

    And Bayern had a 25 point lead last season (for non-football fans, that’s equivalent to 8 wins and a draw in a 38 game season) and they then went and bought the star player of the team that came second. It’s the closest thing to a dead cert there is. Probably even safer than the chance that Aviva or its successors will never ever default throughout your entire retirement.

    Form an orderly line please.

  6. David, for an even worse comparison have a look at some of the traditional providers who, unlike Aviva, are not competitive in annuity pricing, but continue to make considerable profits from very poor annuity rates, usually taken out by existing customers due to lack of promotion of the open market, now there’s the real travesty.

  7. Personally I liked the article. It did in its own way draw the argument that an annuity lock in is not the only way to derive an income and perhaps we should look outside the OMO for outcomes, at least that’s what I took from it.

    Odd how everyone who is negative/sarcastic post their comments anonymously.

  8. I have seen the annuity rates for terminally ill clients with a 10 year guarantee, and you’d expect them to get their capital back over 10 years – but even the best keep 30% of the purchase price.

    Incidentally the FSCS “promises” 90% of the value of the annuity – not 90% of the annuity payment. Two different things – the value of a £1000 income to a 90 year old annuitant – might just be a few thousand pounds!

  9. Thought provoking but I don’t believe in free lunches or that the annuity market is uncompetitive. Further to the other comments above:

    1. About 50% of 65 year olds will live beyond 23 years won’t they (hence annuity rates of c. 5%). So option 2 gives the customer a 50:50 chance of facing a large reinvestment risk. Who knows what sort of returns there will be on bonds in 2036? Never mind – it’s a whole 23 years away!

    2. The Aviva bond (BBB+ rated I believe…) has a return of over 6% while 20 year gilts have a return of under 3.5%. The market probably has a reason for that.

  10. The Richard Bishop Fanclub 20th August 2013 at 4:53 pm

    What a silly article. I’d expect to read this sort of drivel in the Daily Mail (who never shy from a bit of pensions bashing) and not MM.

  11. Thanks for the comments, appreciate the feedback. Am looking forward to @TRBF taking me through the numbers…

  12. It also ignores how you get to £100k in the first place. The tax privilege on the pensions would suggest that this comparison should be between £100k in pensions and maybe £75k to buy the Aviva bond

  13. I think the idea of the article was to provoke interest and comment which it did, NOT to suggest that buying a single corporate bond was a sensible option as a single counterparty approach is pretty much lunacy in the light of Lehmans, Northern Rock and RBS to name but a few.
    However it looks highly likely that wraps will start working with forme annuity providers arranging for the seperation of insurance on the annuity so that a client instead of using someone like MGM for an investment backed annuity (with Vanguard or Jupiter as the fund manager) or the Pru with with profitts linked, instead choosing the level of investment risk they want to take AND the funds selected so NOT just a limited range of investment options with the insured risk being charged seperatly. This would remove the cliff edge which requires non advised consumers, often those in GPPs to opt for lifestyle fund disinvestment as anuitisation approaches as equity levels can be maintained post crystallisation, thus better protecting against inflation.

  14. People get soooo touchy – the broader point I think David is making here is that annuities are often the default option for people retiring but should they be ?

    Locking in to rates at historically low levels doesn’t seem a good default IF it can be avoided based on the clients objectives/needs.

    Moreover the corporate bond example merely provides an example against the margin providers like Aviva are reporting on annuity business which is significant and one of the last products offering such a return on investment (with protection although reassurers help there) – which questions the value for money for clients.

  15. A poor attempt at comparing income drawdown to annuity purchase.

  16. Re Anonymous @6:19pm,


    David clearly indicates likely cost if the Aviva bond was held in a Nucleus Sipp – so this doesn’t have to be a pension/non-pension argument.

  17. I think that there seem to be a few people on here who are being a little critical.

    I believe that David is just trying to highlight that annuities offer a poor return on investment.

    Admittedly, I believe that one reason for the returns being so poor is the guarantees that the providers are giving. This obviously represents a risk to their businesses and their shareholders.

    However, and a big however…… I believe that the providers receive too much reward for the risks that they are taking. I therefore agree with David in saying that the current annuities represent poor value.

    I think that David’s article was just designed to provoke a discussion about rates and alternatives.

    I thought it was very honest in the way that he even explained that there would be cheaper way than his company to hold the suggested asset.

    A nice article, however I think it needs a bit more ‘meat on the bones’ before everyone starts to criticise so much.

    I have been saying for a long time that there must be a better, safe alternative than what is currently available. Maybe David or one of his staff could run the figures if you wereto hold some form of gilt and an element of return of capital to compliment it?

  18. @Steve: If you were to hold gilts yourself, the returns would be considerably lower than an annuity because no mortality cross-subsidy. The current yield on the longest-dated gilt available – 2060 – is 3.54%.

    The price of mortality cross-subsidy is that nothing is passed on to your family, so obviously the gilt works out better if you die early, but if you die early some might say you have a bigger problem than investment returns.

  19. Just before Christmas I interviews a very clued up new customer. He had a PPP with a well known Lifeco worth about £200k. He wanted a SIPP in which to effect drawdown and had brought a list of the corporate bonds he wished to buy to support it.

    At the time my advice was “don’t do it”, simply because I believed most fixed interest securities were vastly overpriced on a buy and hold basis. I looked at the first three on his list in order to demonstrate my point.

    The first one was CoOp Bank. That could have been a fun complaint from an ex/o client.

  20. This is an “apples and pears” comparison. A bond is an investment product. A level annuity is insurance.

    Can I suggest the next article for Mr Ferguson is a stunning expose comparison of the respective financial returns available from gold and home insurance.

  21. Thanks again for the interest.

    For the record the point of the piece was to get under the bonnet of annuity pricing. I’m perfectly aware, for example, that an annuity is an insurance product and a corporate bond is an investment. I’m also aware that insurance products are backed by investments and (in some instances) guarantees which are themselves backed by underlying investments.

    The limited analysis I have done leads me to question:

    a. whether annuities are fairly priced

    b. whether annuities are a sensible option for most people at the traditional point of retirement

    Slightly oddly (and in the midst of writing this reply) I just had someone from a major life company conceding the thrust of my argument is spot on. I guess we’ll see…

  22. Wow, there is some weird comments on this one. David is quite right in his comparison, although few of us would recommend holding just one directly purchased corporate bond.
    Our main difficulty with this is we are advisers, not stockbrokers and to provide a basket of investment grade long dated corporates is not within our remit, therefore we have difficulty with it.
    Simon was pleased with not allowing his client to purchase Co-Op bonds, but did they have a haircut? Certainly the PIBS did, but check before feeling so smug.
    The one fault in the assumption that you will get the £100,000 back is that if you or your darling wife were still alive on the maturity date it is true but needs re-investing. If both died prior to maturity then it is the market rate (less dealing and platform charges) that would be paid. This could be more or less than 100k.
    I have always maintained that a portfolio of individually held corporates are loads safer than a fund if you require income. Interim values are irrelevant unless you have to sell and the nearer to maturity, the nearer to the nominal price they will be. Even if you buy at a higher price than the nominal price, at least you know what income you receive, as well as the maturity price. The only issue, if the issuer goes into liquidation, but if you stick to investment grade bonds, then this is reasonably unlikely. Remember most large firms are bought by someone else before liquidation.
    Spot on David, I like your style!

  23. Currently I work for a large insurance company and am about to become a paraplanner.

    The ABI code means that ‘shopping around’ is trumpeted from the rooftops in all communications. Insurance companies cannot be blamed for 1) Wanting to make a profit and 2) Customers not seeking advice.

  24. I have to disagree with many of the anonymously posted comments and say this is a very thought provoking article. I wonder how many of those commenting anonymously work for life offices or have a vested interest in not rocking the annuity boat!

  25. David, if you were aware one (the annuity) was an insurance product and the other (the corporate bond) was an investment product – why do you pose the question “So, it’s decision time. Would you choose (1) or (2)?” It’s irrelevant.

    If you REALLY want to get under the bonnet of annuity pricing – do so.

    Look at why the corporate bond would or would not be an appropriate whole-of-life investment. Look at any hedging you’d want to do to protect yourself. Look at any regulatory-driven solvency requirements. Then look at what the customer would be left with.

    If you have something substantially higher than the insurance companies – there’s your article.

    Otherwise, it’s best summarised by “somewhere in these numbers are some numbers. I’m outraged.”

  26. Thanks LeeD.

    I should have been more clear. This wasn’t intended as a sales pitch, it was an attempt to rationalise annuity pricing. It seems from some of the feedback on here most of the feedback I’ve had offline that the thrust of my argument is sound. It might need legislation to change or something else to give but that doesn’t mean clients should continue to be subjected to outcomes which were fundamentally designed for a different age.

    There’s a load of further evidence in the profitability of annuity books – if I can find the time (and MM afford me the space) I’ll try and pull something together on that.


  27. David, it’s an interesting article despite what the nay-sayers say. Having people step back and challenge what we do is good.

    However, I do think your argument only stacks up so long as you invest in a BBB corporate bond and assume default will not happen. The market charges a 3% premium for that risk so assuming it won’t happen seems a bit unsafe.

    If you went for a gilt, I reckon the regular payment would be about half of what you calculated i.e. well below the annuity amount. Perhaps all this shows is that insurers tend to invest in AA and A bonds to back annuities?

  28. David,

    ” that doesn’t mean clients should continue to be subjected to outcomes which were fundamentally designed for a different age” – this sounds like a very good, insightful article indeed.

    Globally, the UK solution is comparatively sound. It forces the population to have an income in retirement, reducing some of the burden of older age on the state.

    It would be REALLY interesting to see what level of legislative change the government would support – more income from non-government sources would mean even LESS of a state burden – and which barriers they would consider non-negotiable.

    We’ve moved some way away from the thrust of this article though.

  29. Well done David – you have raised some serious issues

    I explain an annuity as like a mortgage in reverse – the problem is many people only get their money back with a low rate of interest

    what return would a rational investor expect for tying their money up for the next 20 plus years? – the answer is a lot more than is on offer at the moment

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