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Investment edge: Billy Burrows

There are only a few firms offering annuities which means there is not strong competition. The annuity market resembles the supermarket industry – a small number of competitive firms all looking to increase market share.

If annuities were for sale in a supermarket, they might come with a label “buy now while stocks last”.

It is not that the supply of annuities will suddenly be cut off but, over time, annuity rates have fallen and may continue to fall, partly because there is not enough stock to go round.

The current stock of annuities is priced according to a number of factors, including:Bond yields.Increased longevity.Increased demand for annuities.Lack of supply of suitable fixed-interest investments.Lack of competition in the annuity market.

Annuities are priced according to the yield on long-dated gilts and corporate bonds and as gilt yields have fallen, so has the inc-ome from annuities.

For instance, an inves-tor who is considering buying a 100,000 annuity would have been able to get 400 a year more if the annuity had been purchased in August 2004 compared with today. This may not seem a lot but it is 400 a year, before tax, for the rest of the inves-tor’s life.

It is always difficult to second-guess financial markets but there are many reasons why it seems that yields may remain low. This inc-ludes the absence of serious inflation and strong demand for gilts.

Increased longevity seems here to stay. I have heard arguments that my son’s generation may not be living as healthy lifestyle as me but medical progress is bound to continue finding ways of keeping us alive for longer.

There has been talk about so-called longevity bonds that will help insurance companies hedge against longevity risk. This is an area about which I should know something about as I co-authored one of the first papers on this subject.

However, I am not a numbers man and did not get to grips to the maths – this was done by my more academic colleagues – but I remember thinking that there was not going to be any free rides and it was difficult to see how the Government would effectively underwrite annuities with public money.

Therefore, individual clients may have to wait a long time before these types of bonds will produce a noticeable increase in annuities, if ever.

The increase in the number of money-purchase pension schemes will result in more annuities being purchased. The annuity market is currently valued at 7bn and is forecast to increase to over 12bn by 2012 and this will add more pressure to the supply side of annuities.

However, the new rules for alternatively secured pensions, which will be introduced as part of pension simplification in 2006, will allow drawdown after the age of 75 and may red-uce the demand for bigger annuities.

There has been much talk about the lack of availability of suitable investments for annuities and how this will seriously constrain future capacity.

Some industry professionals believe that there is no shortage of investments while others maintain that the lack of supply will result in ever lower annuity rates. The recent Government initiative to consider long-dated bonds is a welcomed dev-elopment.

Finally, we come to the issue of lack of competition in the annuity market. Those who think that annuities are a rip-off because life companies make a huge profit from annuities should ask why more companies do not provide annuities.

The answer, of course, is that annuities are not as profitable as many think and the margins are very thin. Even an increase of just a few months can seriously reduce the profitability of annuities.

There are only a few companies offering annuities and although this makes shopping around easier, it does not mean that there is not strong competition.

In fact, the annuity market resembles the supermarket industry. A small number of very competitive companies all looking to increase market share.

There are obvious differences. Supermarkets are quick to innovate and know a lot about meeting their customer’s expec-tations but the same can-not be said of the annuity market. But they do have a lot in common in that both strive to offer their customers the best value for money.

It is just that it is easier to convince customers that they are getting better value shopping at a supermarket as opposed to shopping around for an annuity.

Billy Burrows is a director of www.williamburrows.com

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