Global stock markets have tried to shrug off the Brexit effect since the vote to leave the European Union, but the impact for savers and retirees is only just starting to emerge.
With the Bank of England reducing interest rates to 0.25% last week, savers will continue to struggle to earn any interest on their bank and building society savings. The reality is that interest rates were already so low that this latest cut may not have much more of an impact, but it does signal a further realisation that interest rates will remain historically low for a long time to come, so the need to look for alternative ways to generate a return continues. The prospects for negative interest rates in the UK are unclear at this time and it would be an indictment for a failing economy if rates turn negative, but it is a warning for savers that the possibility of having to pay the banks to hold our money with them rather than they paying us with interest still hovers.
The impact of reduced interest rates has further diminished annuity rates. Several annuity providers had already announced cuts to historically low annuity rates prior to the interest rate announcement last week, which spurred other providers to follow suit. Two crucial components which go towards the calculation of annuity rates are interest rates and gilt yields. Gilt yields are likely to fall as interest rates fall and as further economic stimulus is required with the Treasury and Bank of England pumping more money into the economy to stimulate growth.
A 65 year old male looking to retire today with a pension fund of £100,000 available to buy a level income (guaranteed for 5 years) with a 50% widows pension can expect an annuity rate of 4.5% per annum (£4,500 pa). The rate falls to 4% per annum (£4,000 pa) if the five year guarantee is replaced with a 100% widows pension for life. Annuity rates have averaged between 5% and 6% per annum in recent times for the same options as illustrated here. The message is clear, anyone looking to retire and draw their pension as an annuity needs to seek advice before they set it up.
The conundrum is that an annuity may be the best solution for some clients, it isn’t true to say that annuities are no longer viable forms of drawing retirement income, but there is a question mark over whether or not locking into these all time low annuity rates now are the right thing for the client to do.
Pension providers have improved their methods of informing clients of the option to compare the level of income available from their existing pension with alternative annuity providers, but still the default client action is to fill in the forms sent by the existing pension provider 6 months before their retirement date and not seek advice or alternative options.
An annuity is an option for life and doesn’t change throughout retirement, which for some people could be 25 years. Locking into a rate of 4% to 4.5% today for such a long period of time needs consideration and a thorough analysis of individual retirement needs and expectations to ensure that anyone buying an annuity today understands what they are going to receive.
The impact of falling gilt yields affects final salary pension schemes as well. As interest rates and gilt yields fall, the liabilities (i.e. the pensions in payment which pension schemes have to fund) increase. If the liabilities increase then the scheme has to find more money to fund the pensions ongoing and if there are insufficient monies, then the scheme can end up in deficit, which is where all the problems really begin. As stock markets have rallied in recent weeks, the impact of falling interest rates and potentially gilt yield cuts has been slightly offset as the funds have grown within the scheme, but if we see a period of market uncertainty and growth starts to slow again, then it is possible to see more final salary schemes struggling to meet their liabilities and scheme assets falling.
To ward against this, we have seen increasing numbers of final salary schemes offering increased transfer values to members. These are not being offered by schemes which are in trouble, but by some of the largest employers in the UK who are looking at future liabilities and offering increased transfer values to members of all ages to make it more attractive for them to leave the scheme early. The default with a final salary scheme is that the members should remain in the scheme unless there is a compelling reason to do otherwise. In this case the schemes seem to be saying, there isn’t a compelling reason for the member to leave and based on a “normal” transfer value calculation, the members would all remain in the scheme due to the risk of the transfer value not providing sufficient benefits elsewhere to replace the guaranteed, index linked benefits available within the scheme. So the schemes are offering increased transfer values whereby the value is so much higher than “normal” that the annual pension on offer within the scheme looks unattractive relative to the value. If the transfer value were invested elsewhere, the “excess” transfer value offered provides a buffer should markets fall in future so that the member has a chance of generating similar income levels from their private scheme as they would have from their company scheme, albeit without the guaranteed, index linked advantages. In addition, with some of these transfer values being so high, there are additional considerations for members surrounding the flexibility of their pension fund ongoing and how they wish to utilise it during their lifetime and leave it after their death.
Transferring away from a final salary scheme is a high risk business and just because a transfer value is higher, it doesn’t mean that transferring out is the right thing to do, but with interest and annuity rates falling, we can envisage more schemes looking to the future and trying to offload more pension pots early to bring down their future liabilities to at least limit the damage in years to come. Final salary schemes are valuable and the view has to remain that without a compelling reason to do otherwise, members should remain in the scheme, but it is worth members checking what their transfer values are under current conditions and making an informed decision based on that information. Transfer values are likely to fall in the future when interest rates, annuity rates and inflation start to rise again and so this unintended consequence of Brexit may not apply indefinitely.