19th March 2014
As I am putting metaphorical pen to electronic paper, UK life insurers are getting well and truly clobbered following the pension changes unveiled by Chancellor George Osborne in today’s UK Budget.
Insurers suffer precipitous share price falls
The annuity specialist Partnership Assurance has lost 52% so far today, while life insurer Legal & General has dropped over 13% and Standard Life over 6%. The trigger for these precipitous share price declines has been the announcement that pensioners will no longer need to take out an annuity with their private pensions when they take retirement, but will instead be take out as much from their private pensions as they like, without restriction.
The situation prior to today
Without going into too much detail, as I am not a tax adviser but rather an investor, let’s recap the situation prior to today. A prospective pensioner with a defined contribution (also called “money purchase”) private pension could take 25% of their private pension out in cash tax-free at the time of retirement – as has been the case now for many a year.
No more annuities?
The Chancellor’s pronouncement today, releasing pensioners from restrictions on their private defined contribution pensions, has been translated into a collapse in the future demand for annuities, as pensioners will now be able to withdraw as much as they like from their private pensions. Of course, this pension income will be treated as taxable income, potentially raising much-needed further income tax revenues for the HM Revenues & Customs.
This has been quickly translated by the stock market as: “There is no further need for annuities, and therefore demand for annuities is going to dry up”.
Flexible and Capped income drawdown has existed since December 2010
Now let’s analyse this statement in a little more detail. First of all, even before today’s Budget announcement, pensioners did not have to take out an annuity with a defined contribution private pension, by age 77, as had been the rule up to end-2010.
Since December 2010, a system of amended income drawdown has existed, where pensioners were able to leave money invested in a defined contribution pension or Self-Invested Personal Pension (SIPP), and draw down a percentage of this private pension (limited by the UK Government) each year as pension income, leaving the rest of the pension invested.
Annuities still offer some benefits…
So OK, these income drawdown limits have been removed, making this alternative to taking an annuity more flexible and thus more attractive. However, I would argue that for the vast bulk of pensioners, there are still clear benefits to taking out an annuity with at least part of their private pension pot:
1. An annuity gives you a guaranteed level of income for the rest of your life, like a form of insurance. Yes, if you die early, you may lose out as there is nothing of an annuity to pass on to your relatives.
2. However, if you outlive the life expectancy built in to your annuity, you are then benefiting from this insurance as you will be receiving more pension income than had been estimated by the insurance actuary, based on average life expectancy!
3. With any form of income drawdown, you are still exposed on your pension investments to the vagaries of financial markets, so you can lose money as well as make money on your investments. Not necessarily something you want to deal with when a pensioner. But if you instead put all your pension into relatively safe bonds, for instance, you still have to deal with reinvesting your money when the bonds reach maturity. And with bonds, you will not necessarily do any better than with an annuity anyway…
Life insurers do more than just annuities these days…
What is more, the stock market is assuming that the insurance companies concerned do nothing to prevent this annuity business from leaving them. But one would do well to remember that the likes of Legal & General are also very big asset managers, so those who do not decide to take out an annuity with Legal & General may well keep their pension pot invested with Legal & General anyway, allowing them to generate alternative investment-related revenues.
All in all, I would come back to the point that pension legislation in general still remains somewhat complicated, thanks to all the various changes enacted by successive Governments over the years, and that the average person coming up to retirement age will not necessarily forgo the purchasing of an annuity – after all, if you are optimistic on how long you are going to live, why wouldn’t you take out an annuity at least with part of your private pension, to hedge your longevity bets? And for a lot of pensioners who do not want headaches from their private pensions, an annuity may still be the simplest option.
What is more, if you are someone who smokes a lot for instance, you may find that you can buy an annuity with a relatively generous annual income from a specialist annuity provider, which could well be more attractive than any potential (but variable) gains that you may receive from leaving your private pension invested.
Bottom line: I suspect that the knee-jerk reactions we see in UK insurers’ share prices this afternoon may be somewhat overdone, as their business models have not, as far as I can see, suffered irreparable damage at the hands of George Osborne.
Bumper dividend yields on offer today
Legal & General (LGEN.L) in particular is still a high-quality insurer with a huge and growing asset management division, and today pays a prospective dividend of over 5%!
Standard Life (SL.L) offers a 4.9% dividend yield today and again has a thriving asset management business, with a very strong brand name to boot. Perhaps today is instead a good buying opportunity in these names!