This article was originally commissioned and published in September 2012 for Investment Life & Pensions Moneyfacts publication. It is written by Tom Murray, Head of Product Strategy at Exaxe.
Autumn has arrived. Keat’s season of mist and mellow fruitfulness is upon us and this is relevant for more than the agricultural community. Those who have arrived at their retirement age are about to discover precisely what the fruits of their labour add up to when the total value of their pension pots are revealed to them.
Then, like the farmers, the soon to be ex-workers will have to see just how much money they can get for their particular harvest. Unlike the farmers though, those about to retire don’t have an opportunity to plant for a new harvest, so getting the best possible value for their savings is absolutely essential. This is where the current batch of new pensioners are very unlucky as annuity rates are at an all-time low.
Effects of QE on annuity rates
The current global crisis has led to a massive increase in the printing of money in the majority of OECD countries, including the United Kingdom. The Bank of England (BoE), under its quantitative easing (QE) program, has released an extra £354 billion into the economy and has used that money to buy up government bonds (Gilts), thus raising the price of the bonds and driving down their yields.
Whatever effect this might have on the UK’s economy, and the jury is still out on whether it is beneficial or not, the lowering of Gilt yields has had a profound effect on the annuity market by causing annuity rates to drop precipitously thereby reducing the pension amount that retirees are getting from their pension pot.
End of the line for conventional annuities?
There has been a huge outcry about this in the pensions’ media in particular and the wider media in general. The issue has brought annuity returns to the forefront of the public’s mind in a way that few pension or life assurance issues ever have been able. However there has been no sign of any of this affecting the thinking of the monetary policy committee (MPC) of the BoE. There is still a huge push both inside the committee, and from former committee member on the outside, to continue with the QE policy in order to try to stimulate lending in the wider economy. It is as if this is the only economic issue in the UK that needs to be addressed.
Meanwhile, aspiring pensioners are left dangling like a Mayor of London on a zipwire, stranded by the lack of low-risk alternatives to an annuity that, at current rates, are a very bad return for years of saving. It is also hard to see how any adviser could be regarded as giving good advice to a pensioner if he recommends that they buy annuities at the current rates available. At current rates, conventional annuities no longer provide any value to those who need to secure an income.
No cavalry in sight
It is clear that there will be no change in BoE policy without a major change in the global economic situation, which is not looking likely in the medium term. In fact, the majority of commentators are expecting a major increase in the QE programme in November.
This means that annuities are poor value for pensioners and are likely to remain so for the foreseeable future. So what should advisers and the industry in general be encouraging those retiring currently to buy in order to get a decent return on a lifetime of saving?
Alternatives to conventional annuities
There are a number of alternatives that keep cropping up but most of them have significant downsides for the average annuitant. The options are primarily scheme pensions, income drawdown products, variable annuities, and enhanced annuities. The difficulty with the first three is that the income remains invested leaving the retiree exposed to two major risks – longevity and investment risk. This level of risk is too much for the majority of pensioners whose pension pot is far too small to risk any reduction by poor investment performance.
While the GAD rate rules prevent depletion of the drawdown pot too quickly, there is not a lot of benefit for the pensioner in stretching a small amount of money over an even longer period as the longer the pensioner lives, the lower the income will drop at each review unless the investment returns start reaching extraordinary high levels.
Enhanced annuities can give higher amounts to those with poor health but only by ultimately decreasing the amount that can be achieved by the remaining healthy pensioners as that particular pool will now live for longer and therefore will have to have their rates reduced to cope with the lengthened average longevity. Thus increased use of enhanced annuities, while benefiting some pensioners, will ultimately drive down the value of conventional annuities even further, making them even more unattractive for the average pensioner.
Where do we go from here?
What can we do to provide a suitable pension vehicle for the future? In order to work out what’s required, we need to understand what is required by pensioners. Most of them have relatively small pension pots – the average pension pot held by a retiring British worker is a little over £30,000 according to the ABI (Association of British Insurers).
Based on average annuity quotation rates, this would give them a annual income of £1,800 per annum on top of their state pension entitlement. This is a very poor return which doesn’t justify the effort involved in saving and is also not likely to encourage the new wave of savers that are about to start saving due the government’s auto enrolment programme.
Too old to gamble?
Pensioners are not like ordinary investors. They have no tolerance for risk at all because by the time they find out that their investment is not paying off, they will then be too old to have any chance of re-entering the workforce in order to make good their losses by increasing their capital. Surveys of attitudes to risk prior to selling to those with low to medium size pension pots are therefore essentially pointless.
We urgently need a solution which will enable pensioners, who want to avoid a conventional annuity, to have access to some type of investment which will provide a higher return, but will still be one hundred per cent safe for them to invest in. And given the increase in the number of pensioners in the country that is forecast for the next two decades, the provision of such an investment is urgent.
Global problem – UK crisis
The lack of secure investment opportunities is a problem that is affecting all western economies to a greater or lesser extent but it is most prevalent in the UK given the large amount of people with private pension savings in the UK and the level of restrictions around the type of financial products that pensioners are allowed to purchase. This means that the UK needs to be at the forefront of the search for an answer to this problem.
Private industry needs to work with government to come up with long-term investments that can provide decent returns without relying on the vagaries of the equity markets. One of the key opportunities that has been mentioned is the use of pension funds by the government to invest in long-term infrastructural projects. Of course using pension funds to invest directly in long-term infrastructural products is not new but it needs to be organised in a way that is better suited to the needs of the pension industry. At present, they seem designed just to satisfy the desire of the government to fund their investment projects directly from this source as opposed to borrowing in the commercial markets.
Indeed the need for governments to make their projects more attractive to pension funds is underlined by the fact that at a time when governments are desperate for investment opportunities with good returns, the amount of pension funding in infrastructural projects has dropped to £175 billion this year from £186 billion a year earlier, according to the Financial Times. Pension funds are voting with their money very clearly and government needs to respond. It’s clear that better vehicles need to be constructed in order to encourage pension funds to provide the investment government needs while allowing the pension funds access to these secure investment opportunities in a way that suits their needs.
Improving the investment vehicles for government projects is only half the story as to date the government has focused on attracting large pension funds and has ignored the potential of the smaller pension investors, to the detriment of both the government and the individual pensioners. It is in this area that changes to the way these projects are funded could provide investment opportunities for those seeking to grow their pension pots post retirement while also giving the government access to a large pool of funds that they currently don’t tap.
If we can devise better access for individual pensioners to infrastructure funds, we will give the government access to funds at a reasonable rate for long-term projects. At the same time we will provide individual pensioners with the ability to grow their earnings through investment style drawdown products without taking the risks that they currently run, as the returns are ultimately underwritten by the taxpayer.
Access for pooled pension funds
Infrastructural investment opportunities need to be structured to enable individual investment by those retirees who are managing their own investments in order to grow their investment in retirement via the new products as mentioned above. A new way of pooling the smaller funds of those investing their pension pots via a drawdown need to be established to allow access for those who wish to avoid the conventional annuity but still are looking for safe investments to protect their pension. The investment also needs to be reasonably liquid and to have regular payouts to fund the income needs of the pensioners. These requirements should not be beyond the wit of those managing government funds to devise provided that they have the will to do it.
It is vital that we come up with new investment vehicles that can be accessed by individual pensioners to enable them to purchase drawdown style projects without risking their entire future. Otherwise we will be left with far too many pensioners who are below the poverty line and who will ultimately require direct support from the taxpayer. Too many pensioners will spend the autumn of their life in financial misery.
What do you think? Let us know in the comments below!
|Interested in a drawdown solution? Income Plus is a highly flexible, scalable, web-based policy administration solution for the pensions, annuities and wealth management sectors supporting wealth decumulation and at-retirement products (e.g. Annuities, Income Drawdown, etc.). Find out more about this Exaxe product here: http://www.exaxe.com/incomeplus/|