I wrote a piece this week on the pensions industry. It should, I said, be abolished entirely in favour of an extension and expansion of the Isa allowance. I have an almost endless list of complaints against pensions and the way both the state and the industry use them.
But the main one is that the industry has complexity on its side and, boy oh boy, does it ever use it. Most people saving into a pension or being paid out of a pension haven't got the faintest idea how it all works or what it is all costing them. So it costs them too much.
I'm reading No Fear Finance by Guy Fraser Sampson, a lecturer at Cass Business School (if, like me, you know you are never going to do an MBA, you shouldread it as well). In chaptereight, he looks at the uses of discounting with reference to annuities.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
Sign up to Money Morning
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter
An annuity something most retirees end up using their pension to buy is simply a stream of annual cash flows, flows that can be given a net present value via a relatively simple formula. He then looks at the value that modern pensioners get from their annuities.
Annuity rates vary massively, but if you flick through averages, you can see that for every £100,000 you have, you can currently get something in the region of £3,500 a year (3.5%) if you get an annuity that rises by 3% a year (offering some inflation protection) and 6.5% if you get a 'level' annuity (ie, one that doesn't rise in line with inflation).Luckily for my point, these are roughly the numbers Guy uses in his example in which his pensioner has £300,000 with which to buy an annuity.
Let's start with the 'non-level' annuity. Take your £300,000 and hand it over to a provider and for an annuity which he assumes will be paid for around 30 years, he'll give you £10,500 a year.
You might think (were you to understand these things) that the present value of a 30-year annuity of £10,500 is £300,000. It isn't. It is £193,000. Gosh. You might ask why it is that the providers need to charge over £100,000 for their services.
They will answer that it comes down to 'inflation risk'; the possibility that if they themselvesare unable to make a return of 3.5% a year plus inflation over the period, they might make a loss in the end.
Hmm. It is, as Guy says, "up to the reader to decide whether forcing the annuitant to take a hit of over athird of the present value of their pension pot is a fair price to charge for this risk." I've already decided.
On to the 'level' annuity. Here your annual payout on the £300,000 will be £19,800. That's better. Well, it's better until you work out that the present value of a level £19,800 a year is about £256,000. So the pension provider's take is £44,000. And they don't even have to worry about inflation given that they aren't compensating for it.
With this in mind, you might be wondering how long an annuitant would have to live for the annuity to be paid for long enough for its net present value to be £300,000. The answer is to 155.
Guy's final word on all this? "Whatever the case, while these are all matters of commercial judgement and thus it is impossible to say for certain that they have got their figures wrong, it does seem appropriate to suggest that those providing annuities understand present value calculations while those who are forced to purchase their products do not."
-
-
Starling Bank boosts rate on its current accounts to 3.25%
Starling Bank hikes current account rate to 3.25% - up from 0.05%.
-
Hidden energy costs - what the new energy price cap really means for your bill
The latest energy price will come into play this weekend, which will see households pay an average 7% less from 1 October. But hidden costs could actually see many households pay more. We reveal what you could pay from this weekend.
-
Our pension system, little-changed since Roman times, needs updating
Opinion The Romans introduced pensions, and we still have a similar system now. But there is one vital difference between Roman times and now that means the system needs updating, says Merryn Somerset Webb.
-
We’re doing well on pensions – but we still need to do better
Opinion Pensions auto-enrolment has vastly increased the number of people in the UK with retirement savings. But we’re still not engaged enough, says Merryn Somerset Webb.
-
Older people may own their own home, but the young have better pensions
Opinion UK house prices mean owning a home remains a pipe dream for many young people, but they should have a comfortable retirement, says Merryn Somerset Webb.
-
How to avoid a miserable retirement
Opinion The trouble with the UK’s private pension system, says Merryn Somerset Webb, is that it leaves most of us at the mercy of the markets. And the outlook for the markets is miserable.
-
Young investors could bet on NFTs over traditional investments
Opinion The first batch of child trust funds and Junior Isas are maturing. But young investors could be tempted to bet their proceeds on digital baubles such as NFTs rather than rolling their money over into traditional investments
-
Negative interest rates and the end of free bank accounts
Opinion Negative interest rates are likely to mean the introduction of fees for current accounts and other banking products. But that might make the UK banking system slightly less awful, says Merryn Somerset Webb.
-
Pandemics, politicians and gold-plated pensions
Advice As more and more people lose their jobs to the pandemic and the lockdowns imposed to deal with it, there’s one bunch of people who won’t have to worry about their future: politicians, with their generous defined-benefits pensions.
-
How the stamp duty holiday is pushing up house prices
Opinion Stamp duty is an awful tax and should be replaced by something better. But its temporary removal is driving up house prices, says Merryn Somerset Webb.
