Incomes warning on ‘perfect storm’ for annuities

Money. Photo credit: Joe Giddens/PA Wire

Money. Photo credit: Joe Giddens/PA Wire

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A “perfect storm” for annuities could lead to drawdown becoming retirees’ main source of income, Alliance Trust Savings has warned.

Annuity prices, which are based on 15-year gilt yields, fell after the UK voted to leave the European Union, as more people loaded up on government debt as a “safe haven” investment.

The Government too moved into the bond markets via quantitative easing following the financial crisis, and the effect of this two-pronged demand has been an increase in bond prices.

In addition, low interest rates in recent years have also made bonds more attractive than cash, further pushing up the price of gilts.

Gilt yields too have fallen considerably over the last eight years, and after the Brexit vote, 15-year gilt yields fell to an all-time low of 0.9 per cent on August 11.

In fact, at least three gilts have even been trading in negative territory.

While low yields reflect high prices, negative yields mean new buyers are assured of a nominal loss.

Brian Davidson, senior pension proposition manager at Alliance Trust Savings, said: “At such low prices, annuities will be unattractive for many more people, with the disadvantage of very low levels of income far outweighing the benefit of income certainty.

“Rates fell further following the Bank of England’s Monetary Policy Committee’s cut to the base rate of interest at the start of August and, with speculation around a further base rate cut later this year, annuity rate rises seem unlikely.

“A ‘perfect storm’ has been created with the danger being that annuities will simply become unpalatable, resulting in more individuals considering drawdown as the main means of providing a retirement income.

“When considering non-annuity-based retirement income options though, it is essential that individuals give serious thought to their likely income needs throughout the different stages of their ‘retirement’, how long they are likely to live and the level of return (after fees and charges) that they need to make on the pension funds that remain invested to meet those needs. That will, of course, require a balance to be struck between risk and reward – the essence of all investment decisions. With this many ‘moving parts’, informed advice will be invaluable.”

Income drawdown allows retirees to take a portion of their pension fund as income while leaving the rest invested. Although this allows them greater flexibility and control over their pension pot, there is a risk of running out of money if they underestimate how long they will live and withdraw too much money too soon.

Earlier this month, the Association of British Insurers (ABI) released data covering the first full year of the Freedom and Choice reforms, which allow retirees to access their whole pension pot and invest it as they like.

According to the ABI, the data revealed “signs a minority may be withdrawing too much too soon with four per cent of pots having 10 per cent or more withdrawn in the last quarter”.

The figures also show that annuity sales are falling.

Meanwhile, cash and drawdown withdrawals are proving popular with under-70s, with 71 per cent of the value of cash lump-sums being taken out by this age group in the last quarter.

From the first quarter of 2016 – the most recent period covered by the statistics – the average pension pot being used to buy a drawdown product, £52,700, is now less than the average pot used for an annuity, £52,900.

The ABI said this shows that drawdown is now available to a wider market following the reforms.

What is a gilt?

A bond is a form of loan, or IOU. The issuer, or borrower, owes the holder, or lender, a debt and must pay them interest (the ‘coupon’) and/or repay the principal (the original amount lent) at a later date, termed the ‘maturity date’.

Bonds provide the borrower with funds to finance long-term investments, or, in the case of government bonds, to finance current expenditure.

A gilt is a UK Government bond, issued by HM Treasury and listed on the London Stock Exchange. As investment, they are considered totally secure, as the British Government has never failed to make interest or principal payments on gilts as they fall due.

A conventional gilt guarantees to pay the holder a fixed cash payment (coupon) every six months until the maturity date, at which point the holder receives the final coupon payment and the return of the principal.

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