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The flexibility factor

Since our last annuity update, rates have continued their slide downwards. Our benchmark annuity (£100,000 purchase, joint life 2/3rds, man 65, women 60, level payments) was paying £6,080 a year gross at the end of March but this is now down to £5,749, a fall of over 5 per cent. During the same period, the yield on long dated gilts fell from 4.48 per cent to 3.87 per cent. This is roughly in line with our rule of thumb which says that for every 100 basis points fall in yields, a level annuity will reduce by 10 per cent. Over this period, yields have fallen by 60 basis points and the annuity income by 5.4 per cent.

Some recovery in annuity rates had been anticipated because interest rates paid by the UK Government on its borrowings were expected to increase. However, financial markets believe that the recent emergency Budget shows the Government’s intention is to reduce its borrowings and any increase in the yields on gilts and corporate bonds seems to have been postponed as a result. Even if interest rates do increase, and they are not expected to do so before 2011 at the earliest, annuity rates are unlikely to increase by an equivalent amount.

All the evidence points to increases in life expectancy. This steadily erodes the level of annuity income payable from pension savings as the income is expected to be paid for longer.

We can expect more investors to see that it might make sense to have part of their pension income linked to equities

A second problem for the insurance companies when setting annuity rates is that new accounting rules are being introduced for the whole of Europe’s insurance industry. These rules increase the amount of capital required to be held by insurance companies to support their annuity liabilities. This means that providing annuities will cost the insurance companies more and they will therefore pay less. The problem is that nobody really knows what the eventual scale of change will be when these rules come into force in 2012.

Some of the impact of Solvency II rule changes is already built into current annuity pricing but, if negotiations go badly, there could be a further 10 per cent reduction in income.

Annuity rates are likely to continue to drift and reflect shortterm market conditions. Many insurance firms are not keen on writing large amounts of annuity business ahead of 2012. Competition is therefore weak which has helped improve their profit margins over the last 18 months.

However, if the outlook for standard annuities is not favourable, the outlook for flex-ible annuities is more optimistic. Not only can we expect more flexibility in annuities resulting from the new proposals to end the effective compulsion to buy annuities at age 75, we can expect more investors to reach the conclusion that it might make sense to have part of their pension income linked to equities, provided they do not end up taking too much risk.

Steve Lewis
Managing Director
The Retirement Partnership

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