Will Osborne end the great annuity rip-off?

Many retirees will be stuck with annuities

I’ve come up my best retirement planning idea yet: take up smoking. High cholesterol and a little extra weight could also help. Why? Well, your pension annuity could increase by up to 25% by reporting those signs of lower life expectancy.

This is called an ‘enhanced annuity’, and it’s about the only way I can think of to avoid being utterly ripped off by the annuity industry.

The annuity concept was designed when life expectancy was much shorter than it is today. Annuities are basically insurance policies that absorb your pension pot on retirement and in return offer a stipend until the day you die.

There are countless problems with these policies and the industry that pumps them out to unwitting punters. First and foremost, these policies offer awful returns.

Some firms offering annuities provide an income 30% below the best deals on the market. But the worst part of it all is that most retirees (except the very wealthy) are forced buyers of these things.

If this doesn’t turn out as another mis-selling wreck, playing out in slow-mo, then I’ll be amazed.

And because all of this awful press, the government today announces the annuities con is over.

George Osborne’s Budget statement on pension reform looks radical. And such reform always looks radical at first sight.

I’ve yet to see the full details of today’s announcement, and I will let you know the implications in due course. But the fact that the government is the prime beneficiary of the system, kind of suggests we shouldn’t get too excited.

The government needs this cash

The main reason annuities offer such heinously bad returns is because the insurance companies themselves are forced into one main investment: government bonds.

The idea is that if an annuity provider is going to promise an investor an income for life, then the insurer is going to have to be darned sure it can meet the promise. Not least because if the insurer fails to meet its commitment, then it’ll be the government carrying the can.

So, the government says to the insurer, “Right. To make sure you can meet your pledges, you’ll have to invest in the safest investments in town. You’ll have to buy our bonds!”

But as we all know, government bonds are incredibly expensive. Even before quantitative easing (QE), returns from gilts (or government debt) had been on a downward trajectory for the best part of 30 years. And since QE (where the bank of England is a forced buyer of said bonds), yields have fallen even further. Annuity rates have been squeezed to next to nothing.

If you want an inflation-linked annuity, you’ll get something like 3%. So for £30,000 a year, you’ll need a cool million in your pension pot. Worse, when you do finally die, so the insurance policy dies too. There’ll be absolutely nothing to show for your million.

Investment professionals rightly say that if you’re after a 3% inflation-linked return, then you may as well buy an equity portfolio. And, at least when you die, there’s a good chance the portfolio will be worth more than you paid for it in the first place – a legacy for someone (or something).

In fact, by gradually ‘drawing down’ on your equity portfolio capital as you get older, you can enhance your income substantially.

And the good news is that if you’re rich, and can prove a £20,000 income in retirement, then you can indeed opt for the non-annuity approach. You won’t need to hand your legacy to an insurance company.

Even after today’s announcement, you’ll need to prove an income of £12,000 before you can consider avoiding an annuity. For most savers, that’s going to be all but impossible. I suspect most retirees will be stuck with annuities.

Everyone’s dumping government bonds

As we’re all painfully aware, our government, like most in the West, just cannot seem to kick that spending habit. Which means every year it needs to issue more and more gilts. The problem is many investors are dumping government bonds.

Pimco is the world’s largest bond asset manager. Not only has it been cashing out on these expensive bonds on behalf of investors, investors themselves have been cashing out of Pimco. This week, analysts Lipper announced a massive turnaround in Pimco’s fortunes. Over recent years, Pimco has consistently been in the top-five for investment funds, if not taking the number one slot.

However, last year, not only did the fund fall out of the top-five, it fell out of the top-25! Like I say, bonds, especially government bonds, seem so yesteryear.

It’s a story the globe over. China has been dumping US Treasuries. It’s now gearing up for a ‘hard asset’ future, investing in everything from real estate, to agriculture and gold. Who wants near-on bust government debt?

And here’s a real sign of the times. London’s biggest council pension fund this week disclosed that it had boosted its assets by a massive 17% by dumping gilts and switching to equities last year.

You can bet your bottom dollar that other pension funds will be looking on enviously. Perhaps trustees will wonder what the hell they are doing with all this government debt that yields next to nothing and which looks less ‘risk-free’ with every passing year.

Universal pension plans: the government strikes back

It’s against this backdrop that you have to ask yourself the question: is the government really going to allow pension investors the freedom to bypass a scheme that’s known to bring billions and billions of pounds from forced gilt investors to the table?

No. I thought not. Drawdown is an option likely to be left only to the privileged few. Moreover, the government is in the middle of rolling out its universal pension plan. That is, a plan that pushes just about all employees in the private sector into a pension plan. And that means more money for the government. It’s what you might call a ‘book-balancer’ for the bods over in Whitehall.

It’s what governments always do. They balance the books by tinkering with long-term assumptions. Much better that, than actually have to deal with hard realities in the here and now.

Anyway, the point is that for most UK citizens, this means if you’re saving into a pension, then chances are you’ll end up with a scraggy annuity. Given today’s more important Budget announcement, that Isa limits are to be increased to £15,000 a year, then maybe more savers should reconsider where they’re stashing retirement savings.

As we’ve seen today, the government can change the rules on pensions at the drop of a hat. Much more difficult to do so with instant access and tax-free Isas.

Like I say, I’ll let you know about the full ramifications of the annuities deal in due course. But I can pretty much guarantee one thing: it’s not going to be as good as George Osborne just made out in front of Parliament.

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  • JGH

    You say, “if [you] can prove a £20,000 income in retirement, then you can indeed opt for the non-annuity approach. You won’t need to hand your legacy to an insurance company. Even after today’s announcement, you’ll need to prove an income of £12,000 before you can consider avoiding an annuity.”

    That’s misleading, as capped drawdown is available to anyone, regardless of their income. The figures you refer to are when flexible drawdown kicks in. With capped drawdown you are able to withdraw up to a certain percentage of your pension pot depending on your age; with felxible drawdown those limits do not apply.

  • Garyant

    For a decent inflation adjusted return, I would suggest looking into getting a solar array on your home. This provides both an income, and a hedge against future energy costs.

    With a feed in tariff covering all the power you produce – whether you use it or not, as well as “free” power when the sun is shining, and an additional payment for exported power backed by a government mandated scheme, I can’t see a safer investment in today’s market. If the array and its installation are up to standard, even after the 20 year feed in tariff ends, your solar array should still deliver power for quire a few more years – continuing to act as a hedge against rising electricity prices.

    Typical returns are around 6 to 8% annually inflation adjusted for 20 years.

    Expect to pay around £6000 to £7000 for a 4 kW 16 panel array. As with any significant expenditure get several quotes and check reviews or references for your supplier.

    • 4caster

      Solar photovoltaic panels even generate electricity when the sun isn’t shining. Reasonably bright daylight is sufficient. In fact they work better when they don’t get too hot.

  • steveH

    >>Investment professionals rightly say that if you’re after a 3% inflation-linked return, then you may as well buy an equity portfolio.<<

    They would wouldn't they. Evidence please

  • TJ

    Shows a shocking lack of understanding of the current drawdown rules and of the announcement made yesterday to remove restrictions from April 2015. I will, in future, be careful of taking any of Bengt’s advice and analysis at face value.

  • phildude

    I don’t see the new rules on pensions making that much difference to most people.
    You could get capped drawdown before and if you take much more than the allowed (was 120% now 150% of the annuity rate) you would run out of money anyway unless you are really lucky with your drawdown fund.
    I am just about to do something with my DC pot but nothing much has changed it seems to me.
    Am I missing something?

  • 4caster

    Small pension pots may now be taken in cash, rather than having to be invested in annuities. This may provide a new opportunity in Immediate Vesting Personal Pensions (IVPPs).

    IVPPs are available for anyone below the age of 75, and are particularly advantageous when vested in non-taxpayers, including children and income-poor pensioners.

    The IVPP investor can pay up to £2,880 per fiscal year. HMRC grosses this up by the basic rate of tax, whether or not the investor is a taxpayer, adding £720 to make £3,600. Higher rate taxpayers can even reclaim an extra tax refund.

    The vestee can immediately draw a lump sum of 25% of £3,600, i.e. £900.

    That leaves £2,700 in the Personal Pension. Previously this would have to buy a small annuity, meaning it would take some decades to recover the £2,700. But now pension pots of this size can be taken immediately in cash, i.e. the whole £3,600 can be withdrawn, making an instant profit to a non-taxpayer of £720, the HMRC contribution.

    Naturally the pension provider would want to cream off some profit, because the previous means of making a profit will be denied to the company, specifically the opportunity to make outrageous charges on the annuity.

    But with online applications and automation from start to finish, the expenses of running the service could be very low.

    First of all, have I understood this correctly, and secondly, is anyone aware of any plans to run such a scheme?

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