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Quantitative Surveyor

Economic historians conversant with currency vicissitudes over the past couple of hundred years will doubtless be able to seamlessly link Assignats – the paper money issued by the National Constituent Assembly in France during the French Revolution – Confederate dollars in the American Civil War, German Reichsmarks in the immediate aftermath of World War I and Russian roubles following the collapse of communism in the late 1990s. Not to mention the recent hyper-inflation in Zimbabwe.

And, of course, our own recent venture into boosting the money supply, the Bank of England’s controversial quantitative easing. Our economy, dire as it is, is in far better shape than the afore-mentioned but the aim is broadly similar to historical examples like post-WW1 Germany – to get money flowing around an economy when the normal process of cutting interest rates is not working, most obviously when interest rates are so low that it is impossible to cut them further.

The current policy delivers a massive body blow to our annuity system. Since announcing the initiative, 10-year gilt yields have fallen dramatically.

Quantitative easing is intended to lower rates on both gilts and corporate bonds but these are the assets which largely determine annuity pricing. So, the lower yields go, the worse annuity rates get. Pensioners and those about to take retirement income are in a desperate plight.

Most people buy annuities when they retire and nine out of 10 savers are effectively forced to buy one before their 66th birthday because they need the guaranteed income.

To date, seven companies, including insurance giants Norwich Union and Legal & General, have cut their annuity rates since the quantitative easing programme gathered steam. L&G has cut its rates twice by 3 per cent in total.

There are two categories of people taking out an annuity when they retire – those who shop around and those who do not. It is as simple as that.

Around 35 per cent fall into the sensible former category, the other 65 per cent, well, they are at the mercy of what their pension company offers them. Of the 35 per cent who do shop around, the majority, who do not qualify for

an impaired annuity, will take their annuity with one of five companies – L&G, Prudential, Canada Life, Norwich Union and Aegon Scottish Equitable. Most of the top five’s annuity books are invested in corporate bonds and other so-called “low-risk” investments and are not adversely affected by quantitative easing in the short term at least.

But there are many other providers catering for the 65 per cent who have not shopped around who are heavily exposed to Government gilts.

You have a scenario where the differential between the top five commercial rates and the non-commercial default annuities will widen.

On March 4, about the time that the Government announced its QE plans, the 15-year yield index was showing 4.26 per cent. By the time QE had started – around March 12 – the 15-year index had fallen to 3.41 per cent so we can see that the initial effect of QE was significant.

I have used the 15-year gilt index as this is the index which is used to determine how much people can take as income every year from unsecured pension or income drawdown schemes. Not only does QE affect annuity rates but it also has a significant and direct effect on someone going into income drawdown.

For example, Mr X had a fund of £500,000 three years ago and could have taken an income of £39,000 a year from his fund, based on a gilt index of 4.75 per cent.

However, three years later his fund has lost a third of its value, and now, thanks to QE, the Government Actuary’s Department rate has fallen to its lowest-ever level of 3.25 per cent, so the maximum income Mr X can take has now dropped to under £24,000 a year – a fall in income of over £15,000.

It is true to say that this fall in income is mainly due to his fund falling but the significant fall in the GAD rate has compounded that fall. Mr X, however, does have the advantage that may choose to continue to work. His friend Mr Y may not be so lucky.

Mr Y did actually retire five years ago and went into income drawdown, also with a fund of £500,000. Mr Y decided to take maximum income which was set five years ago at the same amount as Mr X of £39,000 except that his fund has now reduced to just £200,000 because he has taken maximum income and the overall fund performance has been poor.

At his quinquennial review, his income must reduce to the maximum now available of just over £14,000 a year, a fall of nearly £25,000 a year. Again, QE is not the cause of such a fall but, once again, it certainly does not help Mr Y who may now face serious financial difficulties.

But there is a final and potentially devastating consequence of QE for those 65 per cent of consumers defaulting into their own company’s annuity product – the majority of which are level annuities – and that is inflation. Higher inflation further down the line is not inevitable but is extremely likely.

Now let us consider Mr Z. Last year, when he was 64, he had a pension fund of £100,000 and if he had retired last year he would have had an annuity of £6,142 a year. Now, he is a year older and his fund has shrunk to £80,000 and annuity rates have fallen by 10 per cent so his annuity now is £4,574.

Let us now assume that the economy picks up, overheats and inflation in five years time hits double digits and that over the next 10 years inflation averages at 7 per cent. This means that in 10 years, Mr Z’s pension will be worth just £2,325 a year, £44 a week from a £100,000 fund of 12 months ago that took him his entire working life to save up for.

With these cases in mind, it would seem that now is probably not a good time to be taking an annuity and quite categorically not time to be defaulting into your company’s own annuity product. However, with QE set to continue, waiting for rates to improve is not the best solution either.

The best advice is simple – shop around for the best annuity now. Also, consider alternatives where an income can be taken but the client does not have to commit to an irrevocable policy. How best can an IFA help clients?

Consider with-profits and temporary annuities, along with income drawdown. Weigh up the pros and cons of index-linked or escalating annuities, if the client can afford to do so. Third-way annuities may also bear fruit.

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