Interest rates up, annuities up!
Annuities are still stuck in the doldrums, but there are signs that rates may be on the rise.
The Bank of England increased the base rate by 0.25% on 2nd November (or as the experts say 25 basis points). This means the base rate has increased back to 0.5% and this is the first increase since July 2007.
But will this result in an increase in annuity rates, and if so by how much?
The short answer
A quick way to predict how much annuity rates may increase is to look at the drop in annuities over the last several years and look what would happen if these cuts were reversed.
|3 years ago – Oct 2014
|2 years ago – Oct 2015
|1 year ago – Oct 2016
|Now - Oct 2017
*Rate for man aged 65, £ 10,000 purchase, single life and level payments. **15 Year gilt yield - FT
See the full chart
If the previous cuts were reversed, for example to where rates where 2 years ago, the benchmark annuity would increase by nearly £ 400 per annum or 8%. Realistically, it will probably be a long time before rates return to these levels, so a few hundred a year increase is more like over the coming months.
Some companies have increased annuity rates and I expect others to follow if yields continue to improve.
The longer answer
To understand the relation between the bank rate and annuity rates we need to understand how annuities are priced and the difference between short term and long-term interest rates.
There are three factors that insurance companies take into account when setting annuity rates:
- Life expectancy
- The yields on long term fixed interest investments
- The cost of capital and other expenses
I don’t have to labour the point people are living longer than in the past, but it is worth remembering annuities are based on the principle of “mortality cross subsidy”. This means that those who live longer than expected have their annuity payments subsidised by those who die sooner than expected. This may seem unfair, but it is the same principle that applies to other forms of insurance such as house insurance. If your house burns down, the insurance pay-out will be more than the premiums you have paid, and this money comes from premiums paid by those who have not made an insurance claim.
Annuities may get a bad press, but they are the only policy that insures your income will continue until you die, no matter how long that is. If there is a problem with annuities, it is not with the concept of annuitisation but with low interest rates.
The yields on long term fixed interest investments
Annuities are priced in relation to the yield long term yields. Annuity companies invest the money from annuity purchases in a wide range of corporate bonds and property, but the long-term gilt yields are a reliable benchmark.
I think the best way to understand annuity pricing is to think of an annuity like a mortgage in reverse; “You pay your money over the annuity company and they pay you back your capital with interest until you die”. If you live longer than expected you get more than your original capital (the point about mortality cross subsidy) and vice versa.
The amount of interest you receive on top of your capital repayments is set at the outset. Think 25 or 30-year fixed rate mortgage.
With interest rates and yields very close to all-time lows, the underlying rate of interest for annuities is very low at the moment. The yield on 15-year gilts (my benchmark), is currently about 1.8% and the implied rate of interest for annuities is around 2%.
A practical example will help. The annuity income for a 65-year-old in good health is currently about £5,200 per annum gross. The mortgage repayments for a £ 100,000 25-year mortgage are £ 5,200 assuming an interest rate of 2.13 %
This means that when people say annuities are paying 5% income, it is important to remember that this is a combination of capital of income and interest. The actual return (interest rate is about 2% assuming normal life expectancy).
See the latest best buy tables Best buy annuities
The cost of capital and other expenses
I will not bore you with the technicalities of the cost of capital, only to say the criticism that insurance companies are screwing their customers by offering so low annuity rates can be turned on its head and argued that life insurance are taking a lot of risk because they are promising to pay upwards of 25 years and they must hold regulatory capital to ensure they can maintain these payments.
Annuities may look like simple policies but the under the bonnet they are complex to price. (drawdown is a complex plan but the mechanics are surprisingly simple)
The two main variables are life expectancy (which changes slowly) and returns on the underlying fixed term investments which change from day to day. Annuities rates are set in relation to bond yields at the time of purchase which means that if yields go up, so will annuity rates (for new purchases).
There is a useful rule of thumb; “for every 100 basis points change in yields, (e.g. 2% to 3%) annuity income changes by between 8 and 10%”.
This means that if yields jumped from say 2% (where I hope they will be soon) to 3% (which seems unlikely in the near future), the annuity for a 65-year-old may increase to about £ 6,000 per annum.
I advise people not to hold their breath waiting for annuity rates to rise because it will probably will a long and slow process.
Finally, the chart below plots annuities and gilt yields over the last 25 years and shows just how far annuity rates have fallen.
If you want to look even further back, look at my chart which goes back to 1990.
Annuities since 1990