No fear of breaking even on an annuity

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 should read it as well). In chapter eight, he looks at the uses of discounting with reference to annuities.

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 themselves are 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 a third 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.”