At what rate do annuities become a good buy?

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In last month’s column, I was downbeat about annuities because of low yields, a disappointing outcome from the FCA’s enhanced annuity review and the U-turn on the secondary market.

This month, yields have increased, and I am more upbeat. Let me be clear: annuities are a long way from getting to the level where they become a serious competitor to drawdown. But there appears to be a light at the end of the tunnel.

During August, the yield on the benchmark 15-year gilt fell to 1.05 per cent; thankfully, not going below 1 per cent. Now the yield is 1.87 per cent and may break the 2 per cent barrier. Yields are rising on the back of the unexpected news around Brexit and the US election.

When I first started collecting annuity data back in 1990, yields were above 10 per cent. By 2000 they were about 5 per cent and by 2015 2.5 per cent. It is unrealistic to expect yields to return to the heady days of the past, but the recent increase raises an interesting question: at what level do annuities become a good buy?

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To make sense of this I need to define what I mean by a good buy. Back in the day, we would compare the returns from annuities with the returns from drawdown on the basis that, in most cases, an annuity was a hard act to beat.

To put it simply, if in 2000 the income from a £100,000 joint life annuity at age 65 was about £7,000, this meant a drawdown plan would need to grow by well over 7 per cent (before charges) to maintain the capital value. Today, the same annuity is about £4,200, so a drawdown pot only has to grow at 4.2 per cent to keep its value.

Obviously, these figures are simple and take no account of the mortality drag and the fact annuities have no lump sum death benefit. But they do show that as annuities rise they become more competitive against drawdown.

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What is more, if equity prices start falling because of the uncertainty ahead, drawdown investors could see the value of their funds fall. Drawdown is more flexible than an annuity but it also riskier.

I personally think my benchmark for a joint life annuity at age 65, which is currently paying £4,200 per annum, needs to increase to about £5,000 per annum before annuities become a good buy. The last time annuities were at this level was in the summer of 2015 when yields were about 2.5 per cent.

In conclusion, although I think annuities have a long way to go before they can be regarded as providing a good return, advisers and their clients may have to start taking them more seriously soon.

Billy Burrows is director of Retirement Intelligence