This content is for information and inspiration purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice please consult us here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Early in February, headlines reacted with shock as news broke that banks had been asked to prepare for negative interest rates. The Bank of England (BoE) have given six months to get their IT systems ready, although it was quick to reassure people that negative interest rates will certainly be introduced. The possibility, however, does leave important questions for investors, savers and those planning to retire. In particular, given the crucial link between interest rates and annuities, how might these financial products be affected in such an environment?
In this update, our financial planning team at Elmfield here in Padiham, Burnley, Lancashire offer some reflections on this important question. We hope you find this content useful. If you’d like to speak to an independent financial adviser then you can reach us via:
T: 01282 772938
Why do interest rates affect annuities?
The idea of an annuity is fairly straightforward. In simple terms, you approach a financial firm with money from your pension pot to buy a “product” which provides you with a guaranteed income in retirement. Less clear, however, is how the BoE’s base rate affects the income these products can offer. This is largely because annuity rates tend to move with bond interest rates.
A “bond” is a type of investment similar to a bank loan. You “lend” your money to a government or company (by buying a bond) in exchange for regular interest payments and eventual return of the principal. The insurance companies offering annuities tend to invest their money in these “lower risk” assets to make money (as well as relying on some annuity holders dying early to fund the incomes of those who live longer).
If bond interest rates go down, therefore, these companies make less profit if they continue the level of income offered by their annuity products. As such, the result is typically a less attractive set of annuities for customers to choose from. Bond interest rates, moreover, are impacted by the BoE base rate. If the central bank lowers its rate, then it means that it costs less interest for the UK government to borrow money (which means less profit for the investors lending it). This results in a lower market price for new bonds offered to investors on the market. Current bond holders, however, may continue to enjoy a higher rate of return over the lifetime of their bond – since they originally bought it when interest rates were higher.
The current landscape for interest rates in 2021 is concerning for companies offering annuities. At present, the BoE base rate is 0.10% – the lowest on historical record. Additionally, there is a chance that rates may enter negative territory later in the year, for the first time ever.
What might negative rates mean for annuities?
The good news for current annuity holders is that a change in the BoE base rate should not impact the income from the product you bought. The only concern you may have is whether the company you bought it from may go bust, which could be spurred by a lower base rate. In this highly-unlikely scenario, however, you would have recourse through the Financial Services Compensation Scheme’s (FSCS) insurance rules, which covers 90% of the value.
A further fall in the base rate, however, is unlikely to be welcome news for those thinking about buying an annuity in the coming months/years. Indeed, annuities purchases have already been falling dramatically since the Pension Freedoms of 2015 and as the base rate has gone down. In 2015, annuity sales stood at about 350,000 pa; by 2018, they stood at about 34,000. Income from annuities has also fallen over the past decade. In 2010, a single-life annuity for someone aged 65 could have realistically paid £6,555 per year for £100,000 invested. Today, the same product would likely offer closer to £4,760.
Of course, negative interest rates would almost certainly lead to lower bond yields – which, as we explained above, largely ground annuities rates and so would plausibly also lead to their reduction. If you are thinking about retirement and annuities, therefore, you have some hard decisions to make which may be best thought-out with the help of a financial adviser. Rather than trying to “time the market” (e.g. buying one before rates fall further), there might be other options open to you. For instance, perhaps you could consider a drawdown strategy to better meet your retirement goals. Or, you could contemplate buying successive, smaller annuities as you get older – when interest rates might have risen again.
The certainty of a guaranteed retirement income can be very attractive – especially during a pandemic, when there is so much instability. However, it’s important to not rush into any rash decisions about your retirement planning. This is particularly so when considering buying a product like an annuity, which is a decision you cannot reverse after the “cool off” period.
If you are interested in starting a conversation about your own financial plan or investments, then we’d love to hear from you. Please contact us to arrange a free, no-commitment consultation with a member of our team here at Elmfield Financial Planning in Padiham, Burnley, Lancashire.
Reach us via:
T: 01282 772938