By Tim Gosden, Head of Strategy for Individual annuities, part of Legal & General’s Retirement business
The pension annuity is the core product in the UK retirement income market and it provides the guarantee of a secure income for life that many consumers, especially those with smaller pots, desire. As we are all gradually living longer, the reassurance of a lifetime income guarantee is becoming even more important, especially with an increasing need to cater for long term care. So the value annuities provide should be measured primarily in the context of insurance against living much longer than expected. Equally, as a secure investment, annuities can offer consumers excellent value for money but it’s important that they shop around for the best deal.
Do annuities provide value for money?
There are two types of pension annuity available that offer a guaranteed income for life, the standard annuity and the enhanced annuity. Enhanced annuities offer more income to consumers who are in ill health i.e. have a heart condition or have a lifestyle condition, for example diabetes or they smoke or are overweight. This is because they potentially have a shortened life expectancy and so the higher income secured by their pension fund is likely to be paid over a shorter time. In the external annuity market where consumers are shopping around and in many cases seeking advice, enhanced annuities now account for almost 50% of all contracts sold according to recent industry statistics. Standard annuities were available before the introduction of enhanced annuities and were designed for everyone. However, because more and more people in poor health are arranging enhanced annuities, over time, customers taking out standard annuities are representing an increasingly healthier section of the retiring population, who on average are living longer.
At Legal & General, we have a dedicated team of actuaries and scientists whose role is to predict longevity trends and people’s life expectancy. We do this by analysing our experience of our own customer base of over 750,000 annuitants and by using external research including the latest medical advances and national statistics.
When talking about annuities an average life expectancy of age 83 for a 65 year old male is often and is based on Office for National Statistic (ONS) data. The ONS tables that are used for these predictions of average life expectancy are based on the UK population as a whole, whereas consumers buying annuities are a subset of the population that exhibit very different life expectancy characteristics. They also do not take into account future medical advances that may inevitably improve longevity and which annuity providers do take into account.
So based on our research and considerable experience of the annuity market we expect a 65 year old customer taking out our standard annuity to live on average seven years longer to age 90, and not to age 83 which is often quoted. As mentioned above those consumers taking out enhanced annuities receive a higher income based on a life expectancy estimate that is more bespoke to their personal circumstances.
To illustrate annuity value for money, a 65 year old with an average pension fund of £32,000, in good health, with an average postcode, could currently obtain the best standard annuity of just under £2,000**a year . This is based on the annuity being single life, level, no guarantee, monthly in advance.
On the basis that we expect a 65 with a standard annuity to live on average to age 90 the income received by that age would be £2,000 times 25 years or £50,000. But given that we expect half of our consumers to live beyond age 90, then living to 95, or 30 years would result in annuity payments totalling £60,000. The age at which income payments made would match the initial pension fund of £32,000 is 80.
If security of income is a priority, another way of looking at this would be to instead, invest the pension fund of £32,000 in a Bank Deposit Account to provide an income. If this was the case the Bank interest required to match the annuity income to age 90, would be 4.1% with both capital and income running out. If the customer should live to 100 the interest rate required would be 5.41%. A Bank interest rate of 2.65% would be required to produce the equivalent annuity income with both the capital and income depleting at age 85.
Currently it would be very difficult to find a secure investment option that offers the equivalent terms the annuity provides for a lifetime income guarantee. While there may be other ways of generating an income the annuity guarantee is underpinned by Legal & General and we take the risk of consumers living a lot longer than expected and of investments not performing and we also relieve consumers of the worry that their income might run out.
Certainly in the Bank example above most consumers would probably not wish to reach their mid-eighties facing the prospect of their income running out. This could be particularly difficult if this is at a time when they may need the income to help with care funding.
Insurance is about protecting people from risk, and that’s what pension annuities are all about, protecting consumers if they live longer than expected.
How do we deliver this value?
To match the long term nature of our annuity business we invest in high quality fixed income secure assets such as corporate bonds and gilts. However, we also have a global investment strategy to achieve diversification by territory and sector and we also hold swap instruments, to hedge our exposure to inflation and interest rate risk.
To ensure we can continue to make those payments to each customer, throughout their lifetime we hold more than the level of funds we are required to by the regulator. The latest figure available shows that Legal & General Assurance Society Ltd had a solvency ratio of 195% as at 31 December 2012and is currently rated AA- by Standard & Poor’s and Aa3 by Moody’s. So our customers have the security and knowledge that we have more than sufficient funds to meet their future payments.
In addition, we also invest directly in infrastructure investments. The returns from these property assets are in line with bonds, but with a small excess return due to the lower liquidity of the assets and this help us to achieve the competitive annuity rates we are able to offer customer. This investment also has as a wider social purpose and value. With bank lending being limited, the investment we are making across a range of infrastructure projects, such as care homes and social housing, over the long term, will help to promote much needed growth in the UK economy.
How can customers get better value?
There are many competitive annuity providers that can offer consumers excellent value for money, but there are also not so competitive providers. The ABI window launched last year compares specimen annuity incomes for 28 annuity providers. For a 60 year old with a 24,000 fund the highest standard annuity is £1,336 a year and the lowest is 1,087 a year , a 23% difference. A smoker with high body mass, high blood pressure and high cholesterol could receive £1,483 pa which is 35% more than the lowest standard annuity. Obtaining the best annuity rate is however only one consideration. Other factors, such as provision of death benefits for a spouse or partner and inflation proofing, if affordable, are equally important.
So every consumer should obtain financial advice if they can and shop around the market for the income solution that best meets their personal circumstances.
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