Why your pension may be smaller than you think

Tomorrow, the Bank of England is widely expected to pump more money into the UK economy, through its policy of quantitative easing, or QE, writes Channel 4 News Economics Producer Neil MacDonald. It’s now been pursuing this policy for three years, trying to push money directly towards companies who suffered in the credit crunch.

But there’s now growing concern about how this is affecting another group of people – savers, and in particular people who are about to retire. The key issue is how the Bank of England‘s policies are affecting annuities.

More than 400,000 people buy an annuity each year. It’s a vital part of retirement planning in this country. People who have saved up through their working lives use their pension pot to buy one. In return, it gives them a guaranteed income every year.

But the amount of income you get for your savings has been falling sharply, so the rates now are “pretty catastrophic” compared to a few years ago, according to Tom McPhail of financial advisers Hargreaves Lansdown.

Last month, annuity rates hit an all-time low of 5.6 per cent. What that means is that if you had saved up a pension pot of £100,000, then you could buy an annuity which would pay you £5,560 a year for life. (That’s the rate if you’re a 65-year-old man – you’ll get less if you’re a woman, because you’re likely to live longer).

But go back to March 2009 – when QE began – and your £100,000 pot would have bought you an income of £6,650. So in three years, the income someone could hope to get on retirement has dropped by £1,090 a year – a decline of 16.4 per cent.

If you’re still working, think of it this way. Imagine your boss asks you to take a 16.5 per cent pay cut – you would lose one pound out of every six you earn. Of course, some employees have faced pay cuts during the recession. But the key issue with annuities is that the rate is fixed at the point you buy it.

People are having to lock themselves in at a point when the returns are rock bottom. If you buy an annuity now at this rate, that is what you will receive every year no matter how long you live for. As one big annuity provider told Channel 4 News: “This is a terrible time to retire.”

On top of this, the reality is that most people do not manage to save a pension pot of £100,000 – or anything like it. If you manage to save £40,000 you’d be doing well, and at current annuity rates that would give an annual income of little more than £2,300 a year.

But how far is this due to quantitative easing? The Bank of England has been buying up government debt or bonds – called gilts – in a bid to drive down interest rates. But that’s had a dampening effect on interest rates across the economy, including those on company bonds. The problem is that annuities tend to be invested in company bonds, so lower rates here mean lower rates on annuities.

QE is not the only explanation of all this. People are living longer – there’s been a 50 per cent rise in life expectancy in the last 30 years. So any annuity provider knows that it’s going to be paying out for many more years.

In fact, annuity rates used to be much higher. Go back 20 years and a £100,000 pot would give you an annual income of £15,000 a year – a tidy sum for anyone. Tom McPhail believes a big part of the problem is that many people’s expectations are now out of line with the reality of the marketplace.

The Bank of England is caught between the short-term and the long-term needs of the economy. It’s introduced QE – and it’s cut the bank rate to just 0.5 per cent – because the economy has experienced a severe shock.

It wants consumers and companies to spend more and save less right now, as the Bank’s Deputy Governor explained to Channel 4 News in September 2010. But that means savers lose out in two ways – the money they put aside increases by a smaller amount each year and now it’s producing a much smaller income in retirement.

There’s no easy solution to this. People could decide to delay the point at which they buy an annuity in the hope that this is the low point and rates now go up. But with the Bank of England likely to launch more QE, it’s probably more likely that rates will fall and anyone delaying their purchase will simply get a worse deal in the future.

And there are other reasons lurking on the horizon that might push annuity rates lower. New European regulations under discussion now will tell insurance companies to hold more money to underpin the value of the annuities they are paying out. The more capital that insurance companies have to hold, the more expensive it will be to provide those annuities. So rates will fall further.

What’s vital is that people shop around, according to Tom McPhail. You don’t have to buy your annuity from the company you’ve been saving with over your working life. You can go into the open market and see what rates you can get if you shop around. Bizarrely, any medical condition – or even the fact that you smoke – might be to your advantage in this situation because you might be offered a better rate.