Saying annuities are depressing might sound a bad way to start an article. But that is exactly how most people feel when they realise how expensive they are and how low their retirement income is going to be. The amount that needs to put aside regularly to provide a decent lifestyle in retirement for many is hugely discouraging. Behavioural finance research has found that if too daunting a picture is presented of what needs to be done to achieve an investment objective, people shy away from considering it or simply give up. Unfortunately the way that retirement forecasts are currently being presented is causing many people to do just that.
How much self-sacrifice are people really prepared to make for an uncertain improvement in their retirement income many years in the future? And it is an uncertain improvement. Not only is the return on investments uncertain but so is the cost of buying an annuity, which determines how much income a retirement fund will provide. The problem is that too pessimistic a picture is being presented. The good news is that pensions are likely to be much better than forecast for many people when they reach retirement. The bad news is that they are probably being put off saving for their retirement by these overly conservative forecasts.
Currently most pension forecasts estimate the amount of retirement pots at anticipated retirement age using fixed rate assumptions of the investment returns that might be achieved on retirement savings. An annuity rate is then used to convert the retirement fund into a pension – the higher the cost of the annuity the lower the pension. The annuity rate used for this conversion of retirement fund to pension is typically based on the current yield on index linked or conventional government bonds. The idea is to replicate closely the cost of buying an annuity today.
But due to Bank of England actions in response to the economic crisis the returns on these bonds are currently close to historic lows making an annuity look like an expensive way of providing a pension. This view of future cost of an annuity is likely to be far too pessimistic and may be putting people off saving for their retirement.
There are many potential future scenarios for how interest rates – and government bond yields – may develop from today’s levels as well as, of course, investment returns. Pension providers and employers have begun to recognise the need to provide more realistic pension forecasts – known as stochastic forecasts. Stochastic simply means that the forecast considers more than one possible outcome and enables the likelihood of different scenarios to be assessed.
One of the advantages of stochastic models is they can be designed to adapt to reflect changes in economic conditions so that as realistic as possible a picture of the future is given at all times. This is particularly critical at the present time due to the unprecedented situation created by quantitative easing (QE).
On the one hand, we could be facing a Japanese-type scenario of low interest rates and consequently high annuity costs for a considerable period of time. Alternatively, QE could lead to hyperinflation, 1970s-style high interest rates and cheaper annuity prices. These are two extreme scenarios. In between there are thousands of equally probable future scenarios – all of which imply higher interest rates than today, a lower cost of buying an annuity and, hence, better retirement outcomes.
Stochastic modelling shows that over time the cost of an annuity is likely to fall considerably. Of course, there is uncertainty over the timing and the amount of the improvement but the stochastic modelling behind our Moneybee retirement planner tool gives an idea of what to expect. We believe annuities will be higher than they are now in pretty much all scenarios. For a male retiring at 65 with 50 per cent spouses pension our modelling predicts that five years from now rates will have improved by somewhere between 1 and 19 per cent. In 10 years we expect improvements of between 9 and 21 per cent, while in 25 years we predict rates will be between 15 and 43 per cent better. Crucially, in all scenarios rates are better than they are today.
These ranges allow for projected future bond yields upon which annuity rates are based. We have also allowed for potential future improvement in life expectancy, which will tend to make annuities more expensive over time.
These figures show a potentially significant improvement in pensions depending on the time to retirement. But it is important to remember that higher interest rates, and cheaper annuities, may be associated with higher inflation. So, as always, the news is not all good. So for a complete picture of retirement prospects – inflation and all – employees will need stochastic forecasting tools.