The insurance industry has a reputation for getting one over on customers, but when it comes to annuities – an income for life – some firms may well be lining their pockets to a staggering degree.
The Financial Conduct Authority is concluding an investigation into whether insurers make excessive profits from the annuity market. The Association of British Insurers (ABI) has published a code of conduct to help people better understand their options at retirement, but many experts maintain that until savers are forced away from their pension providers and into the open market, annuities will remain a minefield for savers.
"For as long as the default option is to buy your annuity from your existing insurer, it shouldn't be surprising that over half of investors will end up buying an annuity from the company they have saved with; the inevitable consequence of this is that investors will get a poor deal," says Tom McPhail of the adviser Hargreaves Lansdown.
The lead-up to the introduction of gender-neutral pricing in 2012 offers a prime example of how easy it can be for annuity firms to cash in.
Men used to enjoy higher annuity rates because they have a shorter life expectancy, but the EU forced insurance companies to equalise rates for men and women from December 2012. Pension savers reaching retirement were urged by the industry to purchase their annuities before rates plummeted. Male pensioners were warned they could see rates drop by as much as 10 per cent and, naturally, hundreds of thousands were persuaded to buy their annuities early in an attempt to beat the gender ruling.
The ABI has said that it is wrong to suggest annuity rates were cut significantly in the lead-up to the gender ban. Data on ABI members shows some rates increased and others fell by around 5 per cent. It is also true that other factors, including age, health and lifestyle, play an important part in setting annuity rates.
however, Bob Bullivant, director of retirement adviser Annuity Direct, says it saw new enquiries increase by 100 per cent over this period. "Annuity brokers and insurers put out press releases exaggerating the impact, which led to headlines that men would lose 10 per cent once unisex rates came into force," he says. "The facts were that men were likely to see rates fall by 2-3 per cent. But the surge in demand saw insurers raise their prices – such that men who bought just before 21 December suffered the lowest annuity rates ever and rates have since increased by 10 per cent."
One of the biggest problems is that poor annuity rates mean it takes a very long time for you to get value for money. A 65-year-old with a £100,000 pension pot could buy a standard-level annuity worth £15,600 in October 1990, according to Hargreaves Lansdown figures. Today that figure has shrunk to a miserable £6,271 and it would take 16 years (age 81) for you to get your money back, compared with just over six years in the nineties (age 71).
It's important to remember that annuities are insurance products, not investment products. This means that the longer you live the better value they are, while if you only live for a short time, insurers can make huge sums of money.
Buying a lifetime annuity is one of the most important financial decisions, so it is vital to get it right. An annuity turns your pension pot into a guaranteed monthly income until you die – and once you've bought an annuity, you can't change it.
Make sure you've considered all the options in terms of single-life or joint-life options, escalating and level annuities, as well as additional guarantees if you were to die shortly after taking your annuity. Peter Quinton of Buck Consultants, which has built a new annuity comparison site, retirementassured.co.uk, says that going it entirely alone when you're purchasing an annuity is dangerous, particularly when the number of investment-linked, escalating, enhanced and impaired-life annuities being bought remains low.
"Today, the old 'are you healthy?' question is simply no longer fit for purpose. There are over 1,500 different medical conditions that could lead to an increased retirement income, so everyone needs to go through a dynamic medical question set if they are considering purchasing an annuity. An impaired-life annuity could increase your retirement income by over 40 per cent," says Mr Quinton.
In the months leading up to retirement, your pension provider will offer you a quote for an annuity, but it may be unsuitable if it does not take into account any health conditions or your marital status. Never take the first quote; shopping around is crucial because the difference between the best and worst rates on the market can be as much as 30 per cent. Insurers are even making deals with other providers by splitting revenue, even though better rates may be available elsewhere.
You may also be better off delaying or even avoiding annuities and considering the options of drawdown or "trivial commutation".
With income drawdown you keep your pension invested with the option of taking an income from it. If you have at least £20,000 of guaranteed annual pension income from other sources, you are free to withdraw as much as you like under "flexible" drawdown arrangements. For anyone else, there is a cap on withdrawals. The most important benefit is flexibility and control – at any point you can stop drawdown and buy an annuity – and if you die during drawdown, the remaining fund is passed on to your heirs (minus 55 per cent tax).
There is real investment risk because your money is still tied to the stock market and there are fees and charges for transfers, dealing and advice, so savers with less than £50,000 should stick with annuities. But drawdown also gives your pension pot a chance to grow. If you do buy an annuity later, you'll be older (with shorter life expectancy) so you may be offered a better rate. And if your health has deteriorated, you may qualify for an enhanced annuity.
In comparison, level annuities offer no protection against inflation, which eats away at the spending power of your money; you can opt for an index-linked annuity but the starting payout is often very low.
Trivial commutation enables savers with small pensions to convert their money into cash instead of an annuity. Twenty five per cent can be taken tax-free and the other 75 per cent is taxable as normal income. individual pension pots of £2,000 or less can be converted, or your entire pension savings if the combined value is no more than £18,000.