Tuesday 24 May 2016 5:12 am

Despite paltry interest rates, annuities are making a comeback

I'm deputy money editor at City A.M. I focus on personal finance and investing. I'm particularly interested in macroeconomics, pensions and politics. Contact me at william.railton@cityam.com.

I'm deputy money editor at City A.M. I focus on personal finance and investing. I'm particularly interested in macroeconomics, pensions and politics. Contact me at william.railton@cityam.com.

When pension freedoms were introduced last year, the over 55s were widely expected to shun annuities for more flexible forms of investment for their retirement. Long criticised for their poor value and rigidity, these financial products – which provide a guaranteed income for life – have looked even less attractive in recent years, as rates have been held down by a low interest and inflation environment.

Recent trends

In the nine months after freedoms were introduced, the popularity of annuities was dented heavily. According to data by the Financial Conduct Authority, 540,000 pension pots were accessed and 312,000 were cashed in full. Only 58,000 annuities were purchased – 11 per cent of the total.

Since then, a rebalancing has occurred. Figures from the Association of British Insurers show that, while more money was put into income drawdown products than annuities during the last quarter of 2015, new customers purchased more annuity policies – 21,200 compared with 19,700 drawdown products. Drawdown allows you to keep your money invested, to be withdrawn as a taxable income.

Read more: Five things you need to know about pensions

And FCA data shows that the majority of pension pots accessed between October and December which were fully encashed tended to be smaller in size: 64 per cent of pots less than £10,000 were withdrawn fully, and 46 per cent of those between £10,000 and £30,000. Such sums would be unlikely to buy a reasonable annuity income.

“A large proportion of the population know that they aren’t in the position to take any significant risks with their pension,” says Steve Patterson, managing director at Intelligent Pensions. While pensioners still refuse to shop around for the best deal, Patterson thinks that since drawdown became an option, savers have better understood its risks – namely that the size of their pot could go down in value.

“A lot of it is to do with framing effects,” he says. “There have been surveys carried out which demonstrate that people give high priority to security of income. But it has always been the word ‘annuity’ which has put them off.”

The instability which has plagued equity markets worldwide since last summer is also likely to have reduced appetite for drawdown, and staying invested through retirement.

Read more: Spring clean your finances

And as the UK annuity market has been disrupted, changes to tax policy have allowed insurers to offer annuity buyers a better deal. If you die before the age of 75, you can pass payments from a joint-life or guaranteed term annuity onto a beneficiary free from tax. Some providers are offering 100 per cent value protection and guarantees of up to 30 years.

However, a couple of more worrying trends have also been emerging. First, annuities are roughly 50 per cent less popular with those aged 50-59 than the over 65s. This isn’t a problem in itself; choosing drawdown doesn’t stop you from purchasing an annuity at a later date, and the younger group could still buy one closer to retirement. But 27 per cent of drawdown customers aged 50-59 who made withdrawals took more than 10 per cent of their pot. Taking too much cash could leave those with smaller pots with a reduced income in their later years.

The secondary annuity market

The new-found popularity of annuities may face its biggest challenge after April 2017, when a secondary annuity market finally launches. This will allow holders to sell their annuity to a willing buyer for a lump sum taxed at their marginal rate. Currently subject to a tax penalty of 55 to 70 per cent, selling has before now proved too expensive for most pensioners.

Come April, the government expects that 300,000 retirees will choose to sell their guaranteed income. Patterson thinks that those who sell will have medical reasons for doing so, like terminal illnesses, and herein may lie a problem. “I struggle to see how second-hand annuity buyers will be able to access the correct medical information to do the pricing properly.”

This article appears in the May edition of City A.M.'s Money magazine, which will be distributed with the paper on Thursday 26 May.