With rates soaring, are annuities back in favour?
About this time last year, I wrote an article about annuities, because much publicised increases in rates had been picked up by the radar of the wider public. The conclusion I came to was that, although clearly better than they had been, annuity rates were nowhere near the dizzy heights of the 70s and were still not really attractive.
In 1979 a 60 year old man could, in exchange for £100,000, get an income for life of about £16,000. This time last year £100,000 would buy you £4,135 which didn’t seem like a good deal and if you wanted to include a spouse or partner and increase it in line with inflation it came down to a measly £1,620 pa.
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I don’t think I have to remind anyone that this last year has been cataclysmic! Previously unthinkable events have resulted in a return to World War I trench warfare and double-digit inflation globally, which has pushed up annuity rates further so, clearly, this subject is worth revisiting.
Interest rates have risen sharply, as have annuity rates, so let’s see what £100,000 would buy a 60-year-old man now. A single level annuity would now yield an income of £5,899 per annum which represents a 42% increase from this time last year! The joint life index linked option would now buy you £2,191 per annum, an increase of 35%. The first point to make is that this is bad news for anyone who bought an annuity then. Annuities are a one-way ticket, once purchased there’s no winding back the clock.
Clearly, these rates are higher than last year’s, but do they represent good value? Compared to 1979 they still seem low. They would have to triple, at least, to match them. What this tells us is that back in 1979 there was no light at the end of the inflationary tunnel, so gilt rates (the drivers of annuity rates) remained extremely high. The £16,000 secured in 1979 would have been worth under £8,000 in buying power by 1989.
Inflation is on everyone’s mind and level annuities seem like a fast-eroding income if CPI (the Consumer Price Index inflation rate) remains high. At the time of writing the Bank of England target for inflation is still only 2% which seems almost impossibly low. They may, of course, increase this target at some point in the future, but most experts are of the opinion that inflation will fall (it is starting to edge down already) and the only question seems to be whether inflation will reduce to the low levels seen pre-Ukrainian invasion.
I suppose nobody really knows, but I don’t think I would be alone in considering that 2.19% for a joint life index linked annuity doesn’t really cut the mustard. For some, however, it will. As I mentioned last year, annuities are guaranteed, so you can sleep at night without worrying about investment volatility. It is also true that for older or single people, annuities become more attractive, especially if there is no intention to leave any of your wealth to a spouse/partner or children. For those in ill health there is also the possibility of “impaired life annuities” which offer enhanced rates if you have a reduced life expectancy.
I also pointed out in last year's article that insurance companies secure annuity rates based on market conditions. If the markets think that inflation is going to be high, then this means that the cost of inflation linked annuities will reflect this.
One thing is clear. The argument for annuities is stronger than it was last year. The alternative to buying an annuity is to remain invested in a pension (normally a self-invested personal pension or SIPP) and enter flexi-access drawdown. Over the last year we have seen double digit inflation and falling portfolio values. This is a double whammy with inflation around 10%, when combined with a fall in investments of 10% this represents a real fall in value of 20%. This also tips the scales further towards the annuity route as drawdown does depend upon long term growth.
Historically speaking, however, investments have outperformed inflation when viewed on a long-term basis, so it would be wrong to base a decision simply on the events of one extraordinary year. When comparing annuities to drawdown it is important to step back and look at investment returns in perspective. We have had a bad year, that is true, but over the last 20 years, for a typical balanced managed fund, an investment of £100 would have grown by 155% to £255. Inflation has seen an increase of 101% (Source: FE Analytics – UT Mixed 20%-40% Equity and RPI 20-year performance to 24/01/2023).
This 20-year period has seen several catastrophic events including the Financial Crisis of 2008, Covid and the Ukrainian war, yet the invested money would still have comfortably outstripped inflation. Back in the high inflationary world of the 1970s and 80s, equities were a good hedge against inflation, and high inflation, as I pointed out last year, can kill a level annuity (and cash!).
But there is no doubt that annuities are far more relevant than they were in the recent past. They will never suit everyone and, for some people, annuities would have to quadruple before they would even be considered, as many people want their pensions to pass to their children if possible. For others, annuities could be the cornerstone to retirement planning.
Forgive me for fence sitting but there’s a lot to be said for passing on a considerable pension fund to your children and, at the same time, there’s a lot to be said for having a guaranteed, inflation linked income payable until death. Perhaps for some the answer is a combination of the two? All I am prepared to say with confidence is that whatever the decision, we are all wearing a lot more clothes indoors this winter!
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Please note: Investments and the income derived from them can fall as well as rise and you may get back less than you originally invested. Past performance is not a guide to future returns.