Annuities are one of the oldest financial policies around with their origins being traced back to Roman times, when policies known as annua promised to pay income for a fixed term, or possibly for life. In 1811 Jane Austen wrote, “An annuity is a very serious business; it comes over and over every year, and there is no getting rid of it”, in her book Sense and Sensibility.

If annuities were a serious matter in the past they are even more serious today as over a quarter of a million people buy an annuity each year in order to get an income from their pension when they retire.

An annuity is simply a promise from an insurance company to pay you an income for the rest of your life no matter how long you live. Behind this simplicity lies some very complex mathematics because insurance companies have to work out how long you will live and how much income to pay you each month. If they get the sums wrong and under-estimate your life expectancy you will benefit but they will lose lots of money. However, if they over estimate your life expectancy you will lose out and they will make huge profits. Not surprisingly insurance companies err on the side of caution so no wonder some people think annuities are “legalised theft”.

But legalised theft annuities are not, because the annuity market is very competitive with insurance companies vying with each other to offer the highest income from their annuities in order to persuade you to invest with them. Not enough people know that they can increase the value of their pension income simply by shopping around for the best “open market option annuity” and even fewer know how the annuity rocket scientists, actuaries to you and me, calculate annuity rates.

Annuity Rates

It is helpful to think about an annuity being like a mortgage in reverse, where you loan an insurance company your capital and they contract to pay you back capital and interest over the rest of your life.

Just like a mortgage, when interest rates are high your payments will be higher and if interest rates are lower your payments will be lower. However there are important differences. Once you buy an annuity the rate is fixed so even if rates go up in the future your annuity payments stay the same. Secondly annuity rates are priced according to the yield on long dated gilts (Government bonds) and other fixed interest investments, not the bank rate.

This can be confusing because the interest rates on long dated gilts are normally higher than short term rates and at the moment the bank rate is 0.5% whilst the yield on 15 year gilts is about 4.3%.

  The chart below shows how annuity rates and yields have moved over the last 12 months.

* £100,000 purchase, joint life 2/3rds, man 65, woman 60, level payments - Source: www.burrowscummins.co.uk

A year ago our benchmark annuity would have purchased an income of £ 6,751 for a £ 100,000 investment, today this would provide only £ 6,000 a drop of £751 per annum or 11%.

The main reason for this fall is the government’s policy of printing more money, technically called quantitative easing. The Bank of England has already spent £175 billion on buying back gilts issued by the UK government and consequently the price has risen and yields have fallen. The result is that most major annuity providers cut their annuity rates in response.

Annuity providers do not just buy gilts, they also invest in bonds issued by large companies. Another problem is that the risk of default on corporate bonds is increasing so insurance companies are keeping back more reserves and paying out less to annuitants, and also investing in better quality bonds (which are less likely to default) which do not pay such high interest rates as lower quality alternatives.

The outlook for annuities

Annuity rates will only rise if gilt yields increase. This is likely to happen if the current policy of printing more money results in higher inflation as expected. This is because investors will demand a higher return for locking away their money if they think inflation will erode the value of their investments.

However any gains from increased yields could be wiped out if insurance companies continue to increase their predictions of life expectancy. Other factors such as the continuing developments of enhanced annuities and post code annuities will create winners and losers by increasing annuity rates for some, while pushing rates down for others.

If you live in less wealthy parts of the country, have an unhealthy lifestyle and are in poor health you will get a higher annuity income than someone living in the leafy suburbs with a healthy lifestyle and in good health.