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Osborne’s reforms may not give pensioners the freedom they seek

On top of your savings?

George Osborne has announced that up to 5m pensioners will be able to sell their existing, regular retirement income for cash lump sums. A consultation on how the measure will work will be announced in this week’s budget. But the chancellor is expected to extend pension changes from April 2016, to allow people who have already bought an annuity – a type of insurance that pays an income for life – to cash it in for a fixed lump sum.

The announcement builds on the far-reaching reforms of the pension system announced in last year’s budget. From April 6, radical new pension freedoms come into effect that allow savers to draw out their savings when they like and in any way that they like – as cash lump sums, income or a mixture of both. This widens their options beyond simply buying an annuity which in the past, because of tax and charges, was the usual option. Osborne’s latest measure will extend the new freedoms to people who had already bought an annuity and therefore lost out on last year’s reforms.

For some this has been celebrated for the freedom it gives people over their own finances going into retirement. It is likely to be popular with older voters. But freedom brings with it potential pitfalls for those who wish to sell their annuity – and not because they can’t be trusted to blow their money on profligate spending. Rather, getting a good return on selling your annuity could be a lot more complicated than people expect.

Planning for retirement

A key question for anyone reaching retirement is: how long will my savings need to last? Most of us cannot know how long we personally will live. Using part or all of your pension pot to buy an annuity removes the risk of outliving your savings.

An annuity works by pooling together a group of people of similar age. The excess money left over when someone in the pool dies younger than average is used to fund the ongoing income to people who live longer than average. As with all insurance, with hindsight some people will have claimed (in this case, received income for a long time) and others will not, but all will have had the peace of mind that their income would have carried on however long they lived.

You’ll probably live longer than you think. Jonquil Lowe, CC BY

The cost of an annuity depends not just on how long people will live on average, but also on long-term interest rates. Since the global financial crisis, interest rates, and therefore annuity income, have been dismally low. Once bought, an annuity cannot be reversed. So until now, if you’ve bought an annuity when rates were low, you’ve been locked into a low income for life. The new measures offer an escape route from this low income – but at what price?

Buying and selling

Under the new measures, the annuity will not be cancelled. Instead, you’ll be able to sell it to a willing buyer. The buyer will then receive the income from the annuity for as long as you live. When you die, the buyer’s income stops.

It follows that the buyer will want to estimate how long you will live before making you an offer. So, it seems likely, that anyone wanting to sell an annuity will be required to provide medical evidence before a price can be set. Since buyers are likely to be cautious and there will be some charges for administering the deal, you could end up being paid a lot less for your annuity than you might expect and certainly less than it would cost you to buy the income back.

Buyers are expected to be big institutions, such as insurance companies and pension funds. Osborne acknowledges that buying second-hand annuities would not be suitable for personal investors “owing to the complexity and difficulty in determining a fair price”. This complexity and difficulty – particularly over-estimating how long the original policyholder might live – was why in 2011 the similar sale of second-hand life insurance policies (so-called “death bonds”) was dubbed by the Financial Services Authority, then the UK financial regulator, as “toxic” and banned from sale to mass-market investors.

If the uncertainty over pricing second-hand annuities makes them unsuitable for private investors, it’s hard to see how the same problems will not beset the annuity sellers.

The government has said that its new Pension Wise service will provide guidance and that it will be working with the Financial Conduct Authority (the current UK financial regulator) to support annuity sellers. Given the personal nature of selling your retirement income based on your expected lifespan – and the inherent difficulties of calculating this – the small print of selling on existing annuities is likely to be very difficult. So the freedom that these new reforms bring will be complex and would-be annuity sellers will need good advice that goes beyond the mere guidance that Pension Wise can provide.

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