Is now the right time to buy an annuity?

2013 has been a good year so far for annuities with the benchmark annuity rate increasing 9 per cent since the beginning of the year

The reason for the rate increase is simply that the returns on longer-term interest rates on which annuities are priced has increased significantly. The yield on 15-year gilts has increased from around 2.5 per cent in January 2013 to over 3.25 per cent in August 2013

On 5th September the yield was 3.35 per cent, which is the highest this yield has been since two years ago in August 2011

Yields have bounced up

The recent bounce in yields started on 12th August and yields have increased from 3.04% to over 3.35% since then. Consequently all the top annuity providers have increased their rates. For example Canada has increased rates by about 2%, Aviva by about 1.5% and L&G by about 1.5%

The increase in yields can be attributed to a number of factors, including concerns that as US and European economies improve, inflationary pressure may increase. The imminent end to the policy of quantitative easing (money printing) in the US has also helped. QE has kept long-term gilt yields low for several years, so yields have risen as American politicians have hinted that the policy might be phased out later this year

There is a useful rule of thumb that can be used to predict annuity rate movements. For every 100 basis points rise in gilt yields (in other words, yields moving from 2pc to 3pc, say), annuity income should increase by about 8pc. There is a time lag between changes in yields and changes in annuity rate but this rule of thumb normally applies over a two-month cycle

Forward guidance and the interest rate paradox

Mark Carney, the governor of the Bank of England, recently announced the ‘forward guidance’ policy whereby the Bank will not consider raising interest rates until the unemployment rate falls under 7 per cent

However if inflation rate increases above 2.5 per cent in the medium term the bank could increase interest rates to combat the inflation threat

There now seems to be an ‘interest rate paradox’. Why are longer term interest rates, such as long term gilt yields, rising while the bank rate looks to remain low for the next couple of years?

The answer is that the Bank of England can control short-term rates but the financial markets determine longer term gilt and bond yields

So what does this mean for annuity rates? If one of the effects of ‘forward guidance’ is to dampen down long-term interest rates then we should not expect significant increases in annuity rates in the near future unless there are some surprises in store for example higher inflation

Looking to the future

So will annuity rates continue to rise?

It’s always difficult to predict annuity rates in the future but for annuity rates to rise another 8 per cent as they have done in the first half of the year, the underlying 15 year gilt yield has to increase from its current level at around 3.25 per cent to over 4.25 per cent. In the current climate this seems unlikely

A more likely outcome is that annuity rates may nudge upwards slightly over the coming months but it is unlikely that the second half of the year will see the large increase in rates experienced so far this year

The outlook for annuities for the rest of this year has soured and at the moment it doesn’t seem likely that annuity rates will continue increasing in the run to Christmas, especially as the Bank of England seems to want to keep rates low for the foreseeable future. It’s also too early to know what effect the financial shut down in the US will have on UK bond yields so it’s very important to watch events in America

There is general consensus that annuities will be higher at some time in the future; it’s just that nobody knows when that will be

The advice for anybody considering purchasing an annuity is take as much time as is needed in order to decide what is the right option but once a decision has been made it might make sense to act straight away, as those who defer their annuity purchase in the hope of getting a higher income are often disappointed

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