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Low interest rates and QE make annuity selection critical

Annuity rates are at an all time low and the Bank of England’s decision to resume quantitative easing is unlikely to see rates improve. LV=’s Michelle Cutler says it has never been more important to get the choice of annuity for retiring clients right

The Bank of England base rate has been held at a historic low of 0.5 per cent since March 2009 and whilst this is great news for those paying down debts, it’s been well documented that low interest rates are not great news for retirees.

Our research into the cost of living as a retiree found that pensioners have seen their living costs rise by a third since 2000 which suggests that as a group, pensioners have been served a double blow of low interest rates and rising inflation.

Nowadays, people have to stretch their retirement savings over more years than previous generations, and with the perceived returns on standard lifetime annuities poor, many people approaching retirement may well be concerned as to whether a standard lifetime annuity will enable them to fund the lifestyle they envisage in retirement.

Unlike those in employment, retirees don’t receive promotions or pay rises if an increasing option hasn’t been taken on their annuity, so it is essential that they maximise their retirement income and ensure it can keep pace with the cost of living.

For those currently planning for their retirement the timing of retirement is a key factor. Ourlatest Working Late Indexreport shows that 6.1m of today’s over-50s expect to work past the current state retirement age and 51 per cent of them cite affordability as the key reason whilst a further 11 per cent hope that by delaying their retirement they will benefit from an increase in their pension value.

On average, those planning to defer retirement plan to work for an additional six years; however one in five expect to work for an extra decade.

By delaying retirement, clients have the potential to increase their pension pot but then at the point of retirement many would now argue that a traditional lifetime annuity may no longer be the best value option.

If your client has a lifestyle or medical condition that may shorten their life expectancy(smokes, is overweight or takes prescription drugs) one way they can boost their income is by applying for an enhanced annuity. On average, an enhanced annuity could increase their income by 20 per cent.

However if your client is in good health when they come to retire this avenue will not be available to them.

There are several alternatives known collectively as “third way” products which could prove to be a better fit for many clients, but the number of people taking up these options instead of a conventional annuity has not kept pace with industry developments.

As with all financial products the annuity which suits a client will depend on their needs and their appetite for risk and growth.

For clients who want the option to benefit from future growth while being protected against market volatility, an investment linked annuity may be the most appropriate product. Investment linked annuities offer a competitive level of initial income and because a client remains invested they have the potential for future income growth and a higher level of retirement income in the future.

Investment linked annuities

Investment linked annuities are a flexible alternative for those concerned about making their retirement income last a long time and adviser feedback indicates that there has been a rise in the popularity of these products in the last 12 months. Advisers admit they tend to recommend investment linked annuities when their clients’ funds require inflation proofing or exceed £100,000. However, the feedback also highlighted the fact that over a quarter of advisers do not include investment linked annuities in their retirement planning discussions with clients because of their own unfamiliarity with the product.

Fixed term annuities

Over the last few years, the fixed term annuity market has grown due to the demand for a more flexible product that doesn’t lock people in for the rest of their lives at outset.

A fixed term annuity offers retirees the chance to defer the purchase of their lifetime annuity and retain flexibility for longer over what they do with their pension savings long-term.
Once the fixed term annuity matures a client has the option to buy a lifetime annuity, transfer to an unsecured pension, or purchase another fixed term annuity.

A client may find that by the time their fixed term annuity matures their health has worsened and they are now eligible for an enhanced lifetime annuity, subsequently increasing the amount they will receive in retirement income.

The risk is of course that it isn’t possible to know where annuity rates will be at the end of the fixed term, and that these could continue to fall. However, clients could receive an income uplift if they qualified for an enhanced annuity.

Similarly, someone with a conventional annuity would see their income fall in real terms if the Bank of England increases the base rate and inflation rises.

However, a client invested in a fixed term annuity would be able to benefit from the rise in interest rates once their policy matures and they invest in another annuity product.

Many fixed term products offer clients increased flexibility by way of a break clause which allows them to switch out of the annuity if their circumstances change.

Clients can effectively cancel the contract of their fixed term annuity if they get married, divorced or suffer the loss of their spouse or civil partner; or qualify for either flexible drawdown or an enhanced annuity. The provision of a break clause indicates that providers appreciate that certain things in life can not be planned and that people lives and needs change throughout retirement.

Deciding how to structure income in retirement is one of the biggest financial decisions a client will have to make in their lifetime, especially as once made; most annuities are for life and can not be changed.

There are numerous options available to those in and approaching so it is important that rather than just shopping around for the best conventional annuity, clients are aware of all the options available and will best suit their needs in retirement.

Michelle Cutler is head of investment-linked annuities at LV=

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