A timely reminder: the true value of annuities

Article date: 14 January 2014

We’ve seen a lot of comment recently about the value for money offered by annuity-type retirement income products. This opens up a useful discussion which helps remind us all of the core purpose of these products.

Specific comparisons of value have been made between annuity rates and the yield available from common lower-risk investments such as gilts. However an incomplete comparison of this sort can sometimes miss the true value of a guaranteed annuity income. Such comparisons, as well as a widely-held belief that interest rates may be likely to rise in future, might suggest that an option to “switch annuities” in future is always necessary to offer good value to customers.

The cost of turning on an annuity switching option

Well-informed comment has been made elsewhere about the potentially high cost of such an option. We think it’s also critical that we recognise the underlying value for money offered by conventional annuities.

An example point of comparison used is the yield available from a 15 year gilt, which today stands at around 3.5%. To add a bit more context, here are the redemption yields of gilts with various investment terms:

(whole yrs)
















* Source = United Kingdom Debt Management Office, market conditions as at 10 January 2014.

This demonstrates three very important points:

  1. Whereas short yields remain close to Bank of England base rate at 0.5%, longer “locked in” yields are higher. This indicates that investors already believe in higher interest rates existing in future, and this sentiment is already benefitting longer-term investment yields.
  2. Comparing against only a 15 year investment is not a fair reflection of yields that might support a typical annuity income. Retiring customers generally seek a steady income throughout their retirement. This means they’ll effectively need a “basket of investments” of varying durations to support that income. (Typically around 60% of annuity payments are made before year 15.)
  3. Gilts are not risk free (as we have seen in some of the sovereign debt in the Eurozone) and a better indicator of risk-free return are interest rate swaps which currently offer yields 0.2% - 03% below gilts (but for this example we’ll stick with gilts as they are more familiar).

Annuity providers offer certainty and expertise

As a significant proportion of an average customer’s annuity income will be payable within the first 5-10 years, a weighted average investment return of around 2.9% would be a fairer point of comparison for their annuity rate. It’s worth noting that as well as arranging and managing a “basket of investments” across all our annuity customers, competitive annuity providers use their investment expertise to secure higher returns than could be earned from gilts alone whilst still guaranteeing the payments to the customer. In addition annuities provide a longevity guarantee and these things combined means the underlying yield is significantly higher.

A typical life expectancy of 20 to 26 years is realistic for a retiree (depending on their  health), especially once we consider ongoing falls in mortality rates. However the individual customer’s future longevity will not impact their income payable once the annuity is set up. Crucially, they therefore cannot “run out of pension fund” no matter how long they live. This insurance is based on the pooling of risk between annuity customers – by which individuals are not faced with the uncertainty of their income falling as they enjoy a longer retirement.

To summarise a complex argument

The following points are crucial to considering the financials of how customers retire in the UK:

  • Fair comparisons when judging the value of guaranteed income products.
  • Allowing for both long-term and short-term income requirements.
  • Recognising that the value offered by lifetime annuities relies on competitive providers’ investment expertise and risk management.
  • The importance of ensuring that customers can find and fairly compare different providers.

Considering the many important services (such as longevity-proofing, arranging investments and customer service) that comprise a “conventional” annuity.

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