Does the interest rate on annuities add up for those taking out a pension?
The low interest rate environment is complicating calculations for those about to go on pension
Earlier this year, the Daily Telegraph asked its readers to “spare a thought for Irish pensioners”. Why? Because Irish annuity rates are typically of the order of less than 5 per cent, while British pensioners are enjoying a more bountiful retirement with rates closer to 6 per cent. But why the differential? Could there be another solution to annuities and what impact has the recently introduced Gender Directive had on pricing?
Annuities are typically purchased by pensioners from life companies with the proceeds of their pension policy, in return for a fixed rate of income until they die. For many pensioners they are attractive because they take the investment risk out of your pension. But how much a person gets typically depends on interest rates. Back in the 1980s, for example, you might have reasonably expected to get an annuity rate of about 10 per cent, which would have given an income of about €10,000 a year on a €100,000 capital sum. These days, however, a 65-year-old buying a joint-life policy with a similar sum will probably only get €4,500 a year.
The problem for Irish pensioners is that Irish-based insurance companies invest mainly in European government bonds – and the yields on these bonds are at historic lows.
“At the moment, yields are quite low relative to historic norms although they have picked up slightly,” notes John Geraghty, chief executive of LA Brokers.
For Owen Morton, chairman at Moneywise Financial Planning, annuities represent “notoriously bad value” today. He notes that they now stand at less than half of where they were 20 years ago.
“No-one having a choice in the matter should buy an annuity today,” he advises.
Spouses not protected
One outcome of the current low rates on offer is that, in the search for a greater income, those opting for an annuity are failing to get cover for their spouses.
Morton points to a survey conducted by his firm which showed that some 70 per cent of those who had purchased annuities opted for a single life. “They were under pressure to get as much income as they could,” he says. You could expect your income to drop by about €400 a year on a €100,000 capital sum to get a joint-life annuity.
But if you should die with a standard, single-life annuity, the husband or wife you leave behind won’t get anything. It will go straight back to the insurance company you bought it from.
Another issue is that people are failing to get their income protected against inflation, probably because index-linking your annuity comes at a considerable cost (see table below right).
But despite the risks, 90 per cent of people opt for a flat rate option, Morton says. In an era of low inflation, this can make sense, but should things change, people might struggle to survive on their incomes.
With rates on offer so poor, it makes sense to shop around. One of the easiest ways of losing income in retirement is by being a “captive” customer and sticking with the life company that sold you your pension in the first place.
As the table shows, there are about six main providers in the marketplace, so do your research first and make sure you get quotes from all the providers. And remember, ask about how commissions and charges are affecting your income.
“A fee-based adviser may be able to negotiate a reduced commission on the product giving you a better return,” says Geraghty.
Last December, new European rules under the Gender Directive were introduced which meant that annuity rates can now be offered only on a gender neutral basis. Previously, annuity providers priced products on the basis that men generally have shorter lives than women – meaning women were offered a lower income, as they were likely to live longer.
There is deep dissatisfaction in the industry over the move which flies in the face of the traditional approach of pricing products based on actuarial risk.
For Geraghty, the outcome of the ruling is a small increase in pension income for women and a small reduction in pension income for men taking out a new annuity.
“Rates today have probably settled near the mid-point of the previous male and female rates,” he says.
Delay the annuity decision?
If you are approaching retirement and are nervous about locking into an annuity now, what other options do you have for your nest egg?
Until recently, your options were limited, but approved retirement funds (ARFs) are now available to everyone, provided you meet the income requirements. Up to 2016, you will need to have guaranteed income of €12,700 a year (including your State pension), or a lump-sum of €63,500 to place in an approved minimum retirement fund (AMRF), which cannot be touched until you are 75 years of age (although you are entitled to access the interest this sum delivers).
Opting for an ARF means that your capital may continue to grow; it can be inherited; and you can draw income from it when needed.
However, you will be assuming some element of control over the fund, and an unlucky or poorly thought out investment strategy – or simple bad luck with the market cycle – may see your vital retirement funds depleted.
Worst-case scenario: you could end up with too little money to see you through your retirement.
But the advantages of an ARF are such, that, for Morton, it makes more sense to park your decision on an annuity for the moment.
If the guaranteed income an annuity offers is still attractive to you when interest rates increase, you can revisit your decision.
“If you buy into an ARF today instead, you can still have your requisite retirement income stream and yet revisit the annuity well later,” says Morton, adding that, by this point, you will definitely be older, and interest rates will likely have moved on from their current artificially depressed levels. Indeed the 4.5 per cent rate currently offered on a joint-life annuity at 65 increases to 7.25 per cent if you are 10 years older.
“If you pile straight into an annuity today [which seems a popular option] your goose is cooked; no way back,” he warns.
And it is always possible to examine the merits of a hybrid-type option, which merges elements of an annuity with an ARF.
A sovereign solution?
But there may be another option for those intent on getting the guaranteed income an annuity provides.
In 2011, legislation was passed allowing for the development of sovereign annuity bonds. These provide cheaper annuities, because they invest in Irish amortising bonds, rather than German or French bonds.
The main advantage of such bonds is that – thanks to higher interest rates on Irish government bonds – they pay a greater rate of income.
For example, back when bond rates were of the order of 7 per cent, a sovereign annuity could have paid out a rate of almost 10 per cent.
Now you can expect to get about 7 per cent, which is still significantly better than the rates on offer from the life companies operating in Ireland.
However, they are typically only available to trustees of occupational pension schemes. And, of course, the increased interest rate they offer is reflective of the increased risk – albeit minor – of default which would also leave the annuitant high and dry.
Morton, however, believes there is scope to widen the net, and allow private investors invest in such bonds.
“If I’m short on income and of cautious disposition I might readily buy in to fixed-term annuity, exchanging the entirety of my €100,000 capital in return for a guaranteed income of more than €7,000 [over 7 per cent per annum] over the course of a 20-year period,” he says.
The risk with opting for a fixed-term of course, is that with an amortising bond your capital will be eroded at the end of the term – but yet you might live for another 10 years.
In this regard, Morton recommends that you only allocate a certain proportion of your retirement fund to such a product.
Doing the sums
How an annuity works
If you’re lucky enough to reach retirement with a fund worth €300,000, you might be in the market for an annuity, which will provide you with a guaranteed income until you die.
John Geraghty has done the sums and, if you’re 65 and started looking for a pension last week with a 10-year guarantee, you could expect to get a rate of about 5.052 per cent.
But what does this mean? Well, in simple terms, it would provide you with a pension for life of €15,118.20 a year, or €1,259 a month – ie, you receive €1 in annual gross pension for roughly every €20 in your pension pot.
If you were to die after three years, this sum would still be paid to your estate until the 10th year. After this point, your estate would receive nothing. On the other hand, if you lived to be 100, then you would still receive the pension every year until you die. When you die, the pension ends.
If you were looking for a greater income, you could instead opt for a five-year guarantee. This represents a lower risk for the insurance company and so you would receive a greater pension of €15,346 a year, or €1,278 a month. This correlates to a rate of 5.128 per cent.
Other options you can consider, which might offer greater certainty but will reduce your income, include opting for a joint-life policy, whereby your spouse will also benefit, and an index-linked policy, whereby the income grows with inflation.