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On the level

Hargreaves Lans-down pensions research manager Tom McPhail says the company’s research shows that a worrying 80-90 per cent of investors choose level annuities over increasing annuities which could prove a catastrophe in the face of prolonged high inflation.

Whatever the Pensions Commission recommends as a solution to the pension crisis, the annuity market, with all its baggage of uncontrollable mortality risk, poor investment yields and economic uncertainty, will inevitably play a key role.

Hargreaves Lansdown has analysed 332 annuity investors as part of its ongoing survey of the annuity market and its prevailing trends.

Of the 332 investors, 227 were individuals and 105 were group pension members. All investors made their decisions without getting independent advice so there is a useful insight into the behaviour patterns of investors when left to their own devices.

Almost two-thirds of annuitants went for a single life annuity. According to the Office of National Statistics, over 60 per cent of women aged 64 are married. The ratio of married men to married women is generally close to 1:1 so, even allowing for the fact that there are slightly fewer men alive at retirement age than women, there is still a significant imbalance between the marital status of annuitants and their propensity to buy joint-life annuities.

The obvious question is, what will their spouse live on after the annuitant’s demise? There does not appear to be an easy answer.

Perhaps more worryingly, annuitants show an overwhelming preference for level annuities over increasing annuities. About 80-90 per cent of annuitants go for a level annuity rather than any form of increasing annuity, whether fixed rate, index-linked or a hybrid of the two (LPI). This could be a problem. If inflation falls further, the effects on pensioner prosperity will be negligible. By contrast, if inflation increases from its present level, the impact will be damaging and a prolonged period of high inflation would be catastrophic.

A recent study by Barclays Capital predicts that long-dated bonds are extremely unlikely to deliver good value to investors. They have done so over only two periods in the past 105 years – in the 1930s and the 1990s.

For long bonds, read annuities, which are backed by the bonds. It does indeed, on the face of it, seem unlikely that level annuities, which currently offer such low yields, will deliver good value for money over the expected lifespan of a pension annuity investor.

According to pension review chief Adair Turner, the average retirement age was 63.1 in 1995. Based on current life expectancy trends, this suggest an annuity payment period of around 20 years. This is plenty of time for the corrosive effect of inflation to make itself felt. Logically then, investors should consider paying a premium to secure a hedge against inflation and should buy at least some inflation-linked annuity income with their pension fund.

Remember that the majority of personal pensions are segmented and it is not unduly complicated to split the annuity purchase at retirement to secure some level income and some index-linked income.

It is true that fixed escalation annuities look poor value compared with level annuities if one considers no more than the longevity risk but if the negative impact of increasing inflation is factored into the risk equation, index-linked annuities look like the more attractive of the three options. In the survey sample, just 7 per cent of annuitants opted for an index-linked annuity.

One other statistic which stands out in the research is the fact that around 90 per cent of annuitants go for monthly paid annuities. I am not sure this has any real significance beyond the fact that annuity manufacturers could dispense with the option of quarterly income (3 per cent), half-yearly income (3 per cent) and ann-ual income (5 per cent) without significantly diminishing their proposition to the market.

Invested annuities did not feature in our research but they do appear to be an under-utilised resource. They offer an alternative solution to the inflation-proofing conundrum through their investment in equities and consequent exposure to economic growth after retirement.

Looking ahead, A-Day will bring further changes. Previous research shows that nearly half of annuities are worth less than £15,000. From April 2006, the trivial commutation rules mean that where an investor’s aggregate pension benefits total less than 1 per cent of the lifetime limit (initially £15,000), they will be able to get the entire fund as a lump sum. The new ASP rules mean that annuity refusniks who resent the idea of signing away their accumulated pension capital will no longer be required to buy an annuity. This will presumably reduce annuity purchase volumes among the upper age range.

In addition, limited period annuities, if they prove at all popular, will cause further distortions in annuity buying patterns.

For IFAs, the value of much of this business is highly questionable. The time cost involved in selling and administering an advisory annuity case for a client is going to be at least two hours and very often twice that time. This translates into several hundreds of pounds of costs to be covered by a fee or commission.

The average annuity case is worth £25,000-£30,000 and with commission rates of 1-1.5 per cent, the work appears to be hardly worth the candle. This average case size is offset by the fact that IFAs pick up a disproportionate amount of the but cases but equally it suggests a streamlined, low-cost solution is the logical answer for a significant chunk of the market.

This relatively limited analysis suggests that whatever solutions we develop to address the long-term pension funding crisis, the post-retirement phase needs to make some significant evolutionary progress from its present form.

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