Or what is an Annuity?
This is a question that comes up at every The Pensions Advisory Service TPAS presentation I give although the audience often doesn’t need to worry, as they are typically in public sector pension schemes where pension income is protected from the daily changes of annuity rates. An annuity is where you swap a lump of money for a guaranteed income – usually for life. For most people the lump of money comes from their pension which is usually the largest lump of money most of us will ever have. I use the word guaranteed here as the income is usually provided by a very large insurance company. These monsters are heavily regulated, can provide risk cover cheaply for ordinary people. Competition is ferocious, many rates have come down (not just on car insurance) and clever chaps called actuaries crunch numbers to assure everyone that there is enough money in the kitty to meet claims.
Got a young child with a penchant for maths? Have a look at becoming an actuary - they tend to be very well paid, but then the exams are tough. Forget also the old joke “What sort of guy becomes an actuary?” Someone who finds accountancy too interesting!
But back to annuities – an income for life in return for a capital sum. The government used to sell them until 1837, without any underwriting or medical checks. You may remember from the end of the 1994 film The Madness of King George the baddie played by Ian Holm is paid off after “curing” the King, and a major part of his settlement is an annuity.
Proving that you learn something every day, there is even an Annuity Museum a visit to which, would be interesting for any financial adviser. But there is a problem with annuities. Returns are based on two main factors: life expectancy and medium-term interest rates. Feeling brave? Check your own life expectancy with the Government Actuary Department GAD. Better healthcare means we are living longer meaning lower annuity rates while interest rates have also been low for a while which has the same effect. Annuity rates are less than half of those available ten years ago. Even worse, the difference between what you get swapping your capital for an income for life and what you could get giving it to an IFA who would select an income fund(s) that would allow you to keep your capital, is often only 1 or 2 per cent. As one of my fellow IFAs put it once, Annuities are Theft!
But life expectancy rates vary hugely throughout the UK, so let Ian Cowie in today’s The Daily Telegraph Your Money explain:
Never mind Scottish devolution, a Rab C Nesbitt annuity could boost your pension income
Scottish independence is getting the politicians excited again but most people north of the border could gain more from evolution than devolution. Before my mother and father disown me, I had better explain that I have just been looking at life expectancy statistics – and they make dismal reading for folk who will celebrate Burns Night next Wednesday.
For example, the average man living in Glasgow City will die 13 years and six months younger than his counterparts in Kensington & Chelsea, according to the Office for National Statistics. While medical advances, improved diet and less smoking mean more people across Britain are living longer, the gap between lifespans for different groups of the population is growing, according to new analysis by the Longevity Science Advisory Panel released this week.
The main factor, of course, is money; the rich tend to live longer than the poor. Steven Baxter of Club Vita actuaries – the professional mathematicians who advise pension funds – pointed out that these facts had important implications for people entering retirement.
He said: “People living in different parts of the United Kingdom should take different steps to get best value for their pension savings when they retire. The reason is because of the way insurers allow for differences in life expectancy between different socioeconomic groups by regions in their annuity prices.”
An annuity is a guaranteed income for life, which most members of defined contribution or money purchase pensions buy when they retire. Those who live longest do best but those who die sooner never get their capital back.
So, for example, Mr Baxter said: “People living in the South West, the West Midlands and Yorkshire & Humber, which all have above-average life expectancy, may find buying an annuity attractive but people living in Wales and Scotland, with below-average life expectancy, may find income drawdown more attractive than buying an annuity.”
Life companies have recognised these facts by adjusting most of the annuity yields they offer to reflect the purchaser’s postcode, among other factors. Smokers, for example, are paid higher yields because they are likely to die sooner and collect fewer annuity payments. Non-smokers and residents of well-to-do areas are offered less because they tend to live longer and collect more.
So might it be worth buying or renting a bedsit in Glasgow and taking up smoking before buying an income for life? Professional advisers were divided about what might be called the Rab C Nesbitt annuity. Bob Bullivant of Annuity Direct said: “This would probably work for someone owning two properties as they will need to provide identification for money laundering purposes.
“Such people should get a quote for each postcode. Renting a bedsit is more difficult in terms of identification.”
Life insurers have only themselves to blame if people begin to make the most of different incomes being paid to pensioners in different parts of the country, according to Steve Bee of Paradigm Pensions. He said: “The trend to so-called postcode annuities is worrying.
“If postcode annuity pricing is used as a blunt instrument and people can as a result gain an advantage by moving home in order to purchase one at a better rate, then the maths underlying the pricing of the annuities simply wouldn’t stand up.”
Billy Mackay of self-invested personal pension (SIPPS) specialists A J Bell said: “I have had a look at a selection of annuity application forms and I am not convinced there is a robust argument to be made for renting a place in the hope it will enhance the annuity figure.
“Any pension saver providing a rental address with the aim of inflating their income would run a significant risk of a subsequent reduction in the annuity amount.”
Alan Steel, an independent financial adviser of Linlithgow, said: “Annuity providers always ask if you smoke, but not when you started smoking, and there could be a similar opportunity for people with second properties.
“If you take up smoking and move to Glasgow before buying an annuity, you could be laughing all the way to the bank. But turning up in a string vest with a tin of Irn-Bru would be going too far.”
Pensioners planning to make the most of postcode annuities should always seek independent financial advice. If you think life is unfair, just look at the facts and figures about death.