When annuities come back into play?

What a difference a month makes!

Last month I was downbeat about annuities because of low yields, the U turn on the secondary annuity market and the publicity over some clients not being offered enhanced annuities.

This month I am upbeat because yields have increased resulting in higher annuities. Let me be clear; in my view annuities are a long way from getting to the level where they become a serious competitor to drawdown, but now there is light at the end of the tunnel.

See the chart showing annuity rates and gilts

During August, the yield on the benchmark 15-year gilt fell to 1.05% but thankfully it did not fall below 1% and now the yield is 1.87 and may break the 2% barrier if yields continue to rise. Yields are rising on the back of the unexpected Brexit and Trump election because it seems that interest rates and inflation will rise on the back of increased spending and possibly higher inflation.

When I first started collecting annuity data in 1990, yields were above 10%. By 2000 yields were about 5% and by 2105 2.5%. It is unrealistic to expect yields to return to the heady days of the past but the increase in yields raises an interesting question; ‘at what level do annuities become a good buy’?

To make sense of this I need to define what I mean buy a good buy. In the days when we gave everybody advice about retirement options we always compared the returns with annuities with the returns form drawdown on the basis that in most cases an annuity was a hard act to beat. To put it simply, if in 2000, the income from a £ 100,000 joint life annuity at age 65 was about £ 7,000 this meant a drawdown plan would need to grow by well over 7% (before charges) to maintain the capital value. Today, the same annuity is about £ 4,200 so a drawdown pot has only to grow at 4.2% to keep its value.

Obviously, these figures are simple and take no account of the mortality drag and the fact that annuities have no lump sum death benefit but show that as annuities rise they become more competitive against drawdown. Furthermore, if equity prices start falling because of the uncertainty ahead drawdown investors could see the value of their funds fall. Drawdown is obviously more flexible than an annuity but it also riskier and if the equity markets go through a period of volatility it will expose investors to sequence of returns risks.

I personally think that my benchmark annuity for a joint life annuity at age 65 which is currently paying £ 4,200 per annum needs to increase to about £ 5,000 per annum before annuities become a good buy. The last time annuities were at this level was in the summer of 2015 when yields were about 2.5%.

In conclusion, although I think annuities have a long way to go before they can be regarded as providing a good return, I do think advisers and their clients may soon have to take annuities more seriously.