Looking ahead to the secondary annuity market
The Government is pressing on with the plan to create a second-hand annuity market but will advisers welcome this with open arms or with trepidation?
The plans to allow those who purchased annuities in the past to exchange their annuity income for a cash sum may be good in theory but will probably be bad in practice. I think there are three key issues for advisers to consider:
- How much will people get for their annuities?
- In what circumstances will it be good advice to sell an annuity?
- How will advisers make sure that they get the best deal for their client?
How much will people get for their annuities?
Annuity pricing is very complicated and so it will be difficult to calculate the capital value of an annuity in payment, especially as it will involve turning the pricing assumptions upside down.
Perhaps the easiest way to get a rough and ready idea of the value of a second-hand annuity is to work out the cost of securing the same annuity income today and then applying a discount factor.
For example, if some bought an annuity three years ago when they were 60 paying £1,000 per annum we can get an annuity for someone aged 63 and paying £ 1,000.
To make the maths even more complicated, the lump sum pay-out will depend on the seller’s state of health. When an annuity is purchased, those with shorter life expectancy get higher income and vice versa. However when it comes to selling an annuity the reverse is true as those with the longest to live will get the highest lump sum. So for example, someone who was in good health when they purchased their annuity but subsequently was diagnosed with an illness will get a lot less if they sell their annuity.
For example, an annuity paying £1,000 per annum (£ 83 per month) today might have a second-hand value of around £ 16,000, before tax, for someone aged 60 and in good health. The capital sum will reduce with age and poor health. The same person in poor health would only get about £ 13,000 before tax for every £ 1,000 of annual income.
I have calculated these figures assuming there is a 20% discount on the cost of providing this income today, but this is a pure guess. In practice the buyers of annuities will need to cover their costs and take the risks into account so although we don’t know what discount factors will be used we know it will be significant.
In what circumstances will it be good advice to sell an annuity?
Generally speaking there are three types of historical annuity clients:
- Those will small funds who only bought an annuity because they had no real choice
- Those with above average funds who selected an annuity because they wanted a secure income
- Higher net worth clients who were advised to purchase an annuity as part of their overall retirement plan
Those with very small annuities or “unwanted annuities” as some people refer to them, may find it difficult to resist exchanging their annuities for cash. From an advice point of view this should not be problematic because it can be argued that clients will benefit more from a lump sum rather than small monthly payments.
At the other end of the spectrum are high net worth clients. I think there may be a strong case for those who don’t rely on their annuity payments to get a cash sum into a flexi-access drawdown plan. They could then take a modest level of income, or no income at all, and plan to leave their pension pot to their children. For high rate tax payers this might be particularly attractive.
However, the case will not be so clear cut for those ‘middle Britain’ clients who rely on their annuity income to maintain a certain standard of living. If they exchange their annuity for cash they may not be able to replace the annuity income at the same level and in the worst case they spend the cash and end up short of income.
How will advisers make sure that they get the best deal for their client?
There is little information at the moment but it looks like there will a number of clearing houses that will gather the relevant information and obtain competitive annuity quotations.
One of the most important aspects will be to make sure that the potential buyer has the right medical information from the annuity seller. When buying an annuity people are encouraged to disclose all of their health and lifestyle issues but when selling people may be tempted to disclose less information.
I would envisage an active market in shopping around for the best deal but that will depend on how many clearing houses or annuity brokers will be in the market.
Finally, the second-hand annuity market will be highly regulated and advice will probably be mandatory for those selling annuities over a certain value. However only time will tell how many advisers will want to be active in this sector of the market.
The buyers of second-hand annuities will hope that annuitants take heed of Voltaire’s famous quote; “I advise you to go on living solely to enrage those who are paying your annuities”. The only problem is that far from being enraged, the buyers will be laughing all the way to the bank.