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Annuity rates to fall

Created:

4 November 2008

Written by:

Moira O'Neill

Retiring investors already nursing significantly reduced portfolio values as a result of stock market falls could see significantly reduced incomes due to falling annuity rates over the year ahead.

According to pensions analysts at Hargreaves Lansdown, in August it looked as though annuity rates may have come off the peak, with seven leading insurers reducing rates. The market mayhem during September and early October may have temporarily stopped the slide, but widespread expectations still point to falling bond yields over coming months. (see Chris Dillow's 'Interest rates to collapse')

The benchmark rate for a 65-year-old male is currently 7.7 per cent, but Hargreaves Lansdown thinks there is a strong argument for rates dropping well below 7 per cent over the next 12 months.

Along with gilts, corporate bonds form the underlying investments used to pay annuities. With the credit market seizing up, the yields on corporate bonds have spiralled to unprecedented levels (relative to gilts) and this in turn has allowed insurers to increase annuity rates.

However, government measures to inject liquidity into the market and kickstart lending again will bring interest rates down. Ernst and Young's ITEM club is predicting Bank Base by next year; while Capital Economics has been quoted projecting 2.5 per cent.

In its August report, the Bank of England's central projection for Consumer Prices Index inflation shows it falling to below 3 per cent through the course of 2009.

When the market does start functioning again, bond prices could jump, forcing yields to drop back. This is likely to bring downward pressure to bear on annuity rates.

Looking further ahead, Hargreaves Lansdown says the impact of falls in sterling and escalating government debt could reintroduce upward pressure on rates. This is much less certain, though, and in the short term the pensions analysts feel that the pressures are universally downward.

And the underlying trend for annuities is increasing longevity forcing insurers to lower rates, as annuities will have to be paid for longer. Based on 2005-07 mortality rates, a man aged 65 can expect to live another 17.2 years, and a woman aged 65 another 19.9 years.

Annuities are also undergoing a rapid evolution towards an individual pricing approach where the actual rate is dependent on the investor's health and lifestyle, as seen by the rise of enhanced and postcode annuities. This drags down rates for the healthy and those living in more affluent neighbourhoods.