Annuity shoppers: hold on for better rates

Mark Carney © Getty images
Mark Carney: is he plotting more rate rises?

Although increasing interest rates by a quarter of a percentage point doesn’t seem earth shattering, the Bank of England chief Mark Carney’s decision last week to hike rates up for the first time in more than a decade has several implications for pension savers.

Firstly, the rate rise is significant for state pensioners. The triple-lock system currently promises that the state pension will rise each year by the higher of inflation (as measured by the retail price index); average earnings increases; or 2.5%. Pensioners will see their state benefits rise by 3% next year, courtesy of today’s relatively high level of inflation.

However, the rate rise is mainly aimed at bringing inflation down – so it’s possible that future pension increases may be lower (although you shouldn’t view this as a bad thing – it would be better to get a 2.5% rise with inflation sitting at 1.5%, as that would mean your purchasing power had actually grown).

Next, for defined-contribution pension scheme members, the most obvious impact of higher rates is on those who are considering converting their pension fund into retirement income via an annuity (an insurance plan that pays a guaranteed income for life).

Annuity rates – the income insurers will pay for a given amount of savings – are closely linked to gilt yields (the cost to the government of borrowing over the longer run). Higher interest rates should mean more generous annuity payments.

Annuity rates are already rising. Just after the Bank of England cut interest rates to 0.25% last August, a £100,000 pension fund would have bought a typical 65-year-old man £4,495 a year in pension income, according to Hargreaves Lansdown. Today, the figure is £5,365, after several annuity providers raised their rates in the run-up to last week’s hike. With the Bank hinting at further rate rises to come, it is worth at least considering delaying an annuity purchase in the hope that rates improve further (you’ll also get a better rate if you’re older).

On the downside, each month you delay is a month in which you’re missing out on a payment, so waiting is a gamble – rates must improve by enough to make it advantageous to have foregone income payments in the short term; if interest rate rises don’t materialise over the next 12 months, that may not happen.

For those savers who have opted to draw income from their pension funds via an income-drawdown scheme rather than buy an annuity, the impact of the rate rise will depend on where their fund is invested. So far, this is not a major shift. Rates remain extremely low, both in the UK and elsewhere. For now, that’s likely to continue to support stockmarkets. However, fixed-income markets may be more vulnerable. Yields on most types of bond are currently close to all-time lows.

If higher interest rates mean that investors start to expect more generous levels of yield, then they may begin to switch out of bonds. A sell-off from these levels could potentially turn into a rout. So if you have a significant amount of your pension invested in fixed-income assets – a common position among those with income-drawdown plans – just be sure to monitor the market closely. That said, a rout in the bond market would almost certainly have a knock-on impact for equities as well.

Private-pension savers with some time to go until retirement don’t have to make decisions just yet. Nevertheless, while you shouldn’t allow your long-term investment strategy to be blown off course, it’s worth reviewing your asset allocation and rebalancing if necessary.

Rates rise threatens transfer values

Higher interest rates should help employers who still run final-salary pension schemes (where an employee’s retirement benefits are guaranteed, rather than dependent on the performance of financial markets). The assets and liabilities of these schemes are valued in such a way that higher rates should mean that funding deficits start to come down, relieving the pressure on employers whose schemes are a long way short of having the resources to meet their pension promises.

While this is good news, final-salary scheme members should be aware that one knock-on effect is likely to be that employers make less generous transfer offers in future. Currently, schemes are so anxious to get pension-fund liabilities off their books that they have been offering unusually attractive transfer values to savers who consider moving their money to a different pension arrangement. These offers may become less attractive in the months and years ahead, with employers no longer prepared to countenance such costly deals.

That doesn’t mean that you should rush to accept a transfer offer on the table today – a guaranteed pension income is so generous that it is difficult to justify giving up such benefits. But if you are considering a transfer – and you have consulted an independent financial adviser – you may need to take action sooner rather than later to secure the best deal.

Tax tip of the week

If a property has a granny flat, buyers will not have to pay the higher rate of stamp duty that is normally due on the purchase of a second home. When the new stamp duty rules first came into effect last April, buyers of properties with “more than one unit” (such as a holiday home or granny flat) would have had to pay the extra tax on the whole property.

But after pressure from MPs and insurer Saga, the government changed the rules, so that properties with a granny flat would not attract the higher rate, as long as the annexe is not worth more than a third of the total property price being paid. However, the higher rate will apply if the flat has a separate entrance, its own water and electricity supply and can be sold on its own.