Last week The Times reported that annuity rates had plummeted to an all-time low. The headline was a 25-year low, but I think we can safely say that rates are at their lowest for a much longer time than that. In the 1990s, £100,000 would have bought a 65-year-old an income for life of about £10,000 a year. Today it will buy little more than £4,000 a year.
It’s worse than that actually. Those are not inflation-protected annuities. If you want an income that will maintain its value over time then that £100,000 will buy you an income of rather less than £3,000 a year. Put that another way, spend your working life scrimping to get together a seemingly large pension pot of half a million pounds and all you’ll be able to enjoy is a pension of rather less than £15,000 a year.
Part of the collapse in annuity rates is down to increasing longevity. While the rapid rate of increase has slowed in recent years, life expectancy does continue to rise, even if some seem so desperate to be purveyors of bad news that this slowing in the rate of increase is frequently reported as a decline. Sorry doom-mongers; it’s not that bad.
By far the more important reason for lower annuity rates, though, is lower interest rates. That’s what has driven the most recent decline and it’s what has been behind the long-term decline, especially since the financial crisis.
So far, so unsurprising. The consequences of this shift, though, are far more fundamental to our system of pension saving than either government or those of us desperately trying to save for our old age seem to appreciate.
The first point is an obvious one. Low interest rates as you save and low annuity rates at the point of retirement make it staggeringly hard to save enough to acquire a decent pension. With traditional salary-related occupational schemes pretty much dead outside the public sector, most of us don’t have a snowball’s chance in hell of replicating the comfortable incomes enjoyed by many of today’s retirees.
It is an astonishing fact that most pensioners today are financially better off than they were during much of their working life. Once you take account of housing costs and the costs of bringing up children, they have a higher disposable income in their late sixties than they had when they were in their forties. Today’s 40-year-olds should not look at their parents’ generation and expect anything remotely similar.
These low interest rates have had an even more fundamental effect on our system of private pension provision, though. It’s not so much that private pensions will be lower in the future than they are today, it’s that they will barely exist at all. The truth is we have accidentally destroyed them almost completely.
Low annuity rates made the requirement to purchase an annuity from your pension pot extremely unpopular. Solution? Get rid of the requirement. Since then people have avoided purchasing annuities in their droves. The pension pots most of us save into are in effect just tax privileged savings accounts. They don’t provide pensions in the normal sense of providing a guaranteed income from retirement until death. They are no more pensions than Isas are pensions. In fact, the scandalously generous tax treatment of these pension pots when it comes to inheritance makes them the last thing you want to draw on for a retirement income if you have a choice.
We should celebrate the success of auto-enrolment in getting millions more private-sector workers building up savings accounts. We should not kid ourselves into believing that auto-enrolment is achieving what it was originally designed to achieve, which was a huge extension of pension provision.
Alongside growing life expectancy and increasing regulation, very low interest rates have also played a central role in killing off the sort of salary-related “defined benefit” occupational pensions that many employers used to provide. Just as it becomes far more expensive for me to save for my own pension, low interest rates have made it vastly more expensive for employers to provide guaranteed incomes for future pensioners. So they’ve stopped.
Despite increases in pension age and some cuts to benefits this all means that the salary-related pensions enjoyed by public-sector workers have also become more valuable than they used to be.
I was lucky enough to spend seven years in the civil service. Despite the fact that I’ve been shovelling as much as I can into an individual pension ever since, each of those seven years will be worth about three years of the rest of my working life when it comes to my retirement income.
The most recent whole-of-government accounts suggest a net liability to government from public service pensions approaching £2 trillion (that’s £2,000 billion) — an estimate that has risen as fast as the UK’s growth prospects, and with it long-term interest rates have fallen. The same effect is evident from looking at the required contribution rates.
Just as an example, take the teachers’ pension scheme. The contribution required from employers to cover the calculated cost of providing these pensions has just risen to nearly 24 per cent of salary, with teachers themselves contributing on average a further 10 per cent or so.
The past really is not a good guide to the future. The era of many retiring in their early sixties on a decent pension will soon be over, and is already over for increasing numbers. The main culprit if you wonder why you might need to work to 70 and beyond is not so much your higher life expectancy, it’s those impossibly low interest rates.
Paul Johnson is director of the Institute for Fiscal Studies. Follow him on @PJTheEconomist
This article was first published in The Times and is reproduced here with permission.