Burrows & Cummins
Retirement can involve some tricky financial choices
Many people living in the more affluent parts of the country are being disadvantaged by annuity pricing based on postcodes.
An annuity is a policy, bought with the proceeds of your pension fund savings, which pays you an annual income in retirement until you die.
Most of the top providers are now pricing annuities based on where people live.
The theory is simple: those living in Glasgow and living on a diet of fried mars bars and chips will probably not live as long as those living in Surbiton and buying their food from the local health shop.
The result is that people living in areas with a lower life expectancy get more money each year from their annuity policy as it will have to generate an income for fewer years.
The table shows the effects of postcoding on selected areas, for a man aged 65 buying a £100,0000 annuity for himself only and with fixed annual payments.
THE ANNUITY £100,000 WILL BUY
Annuity pricing should be transparent, and moves towards individual underwriting is a good thing.
But we are concerned that postcoding will disadvantage those living in London, the home counties and other relatively affluent areas.
Two people with the same financial wealth may get different annuity rates because one lives in the south, the other in the north.
In this sense postcoding is a blunt instrument and will have the effect of reducing the value for money from annuities for a large proportion of 'middle Britain'.
Getting better value
One of the ways in which investors can get better value from their annuities is by sharing some of the investment and longevity risk with the annuity provider, in return for potentially higher annuity income.
This can be done buy buying with-profits annuities and flexible annuities, sometimes called variable annuities.
The rationale for these products is that annuities are a long term investment and so should be invested in long term assets such as equities and property, which aim to provide an effective hedge against inflation and have potential for income growth.
Most people need an income which has the potential to grow in order to meet their ever increasing expenditure and life expectancy, but find the cost of conventional inflation-linked annuities too expensive.
With-profits and flexible annuities combine the advantages of an income for life with the advantages of investing in a broad range of fixed interest bonds, property and equities.
Risk and reward
The vitally important point is that instead of being invested exclusively in fixed interest bonds, and therefore providing an absolutely guaranteed return, the income can go or up down in future years depending on investment returns.
The advantages of with-profits and flexible annuities are:
• they combine the advantages of an income for life with the potential advantages of investing in the stock market
• with-profit annuities provide smooth investment returns, ironing out investment peaks and troughs
• flexible annuities can be invested in a wider range of funds and some have an underlying income guarantee.
But the risks are:
• future annuity payments may fall in value if future investment returns are lower than expected
• the real value (allowing for inflation) of annuity payments will fall if inflation is higher than any increases to the annuity
• increases in future life expectancy can be passed on to the policyholder through reductions in future bonuses or increased charges.
With-profits and flexible annuities are normally only suitable for those investors with larger funds and those able to take the higher risk associated with these products.
However investors can split their annuities between guaranteed annuities and investment-linked policies, in order to achieve a balance between security and potential for growth.
2009 will be remembered as the year of the "annuity crunch".
The income from our benchmark annuity fell by 8% during the year.
In January 2009, a £100,000 joint life annuity for a man aged 65 and woman aged 60, with two thirds spouse's pension and level payments, paid £6,439 per annum.
But by December 2009 this had fallen to £5,897 per annum.
The main reason was the big fall in government bond (gilt) yields caused by the government's policy of quantitative easing, or printing money as some prefer to describe it.
The Bank of England has injected money into the UK economy by buying gilts and this has pushed up their prices and consequently the yields fell.
However the effect of falling annuity rates may be offset by increases in fund values for those invested in equities.
For example in the year ending December 2009 the FTSE 100 index rose by 17%.
We think that 2010 will be a better year for annuities as we have already seen the first green shoots of a recovery in rates, but we do not hold out much hope of significant increases in the months ahead.
Many investors will not have much appetite for taking investment risk following the recent meltdown in equity prices.
But we do expect more investors to consider a combination of guaranteed and investment linked annuities as they look to get better value from their annuities and compensate for the effects of postcode pricing.
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