"The future looks grim indeed," says Aries' Ian Neale as he discusses annuity rates.

Annuities have been in the news a lot lately, with the ABI publishing a snapshot of comparative rates from different members (while failing to explain the factors which might contribute to an entirely different picture taken on another day). Some say the best option is to defer taking an annuity because they are currently poor value - a perception we noted was just as widespread thirteen year ago. MGM pointed out that this is not a no-risk option though, because rates might never improve.

Annuity rates have plummeted over the last twenty-five years. Good news has been hard to come by. Despite occasional blips (up 8% since January 2013), in the overall long-term view, the decline seems inexorable. The future looks grim indeed.

Other factors come into play, of course. There is a close correlation with interest rates (and inflation). MGM calculated that if a 65-year old delayed annuity purchase by two years, annuity rates would have to go up from current rates by around 6% for total income (over an average retirement) to be the same. It seems likely that at some stage interest rates will rise (they can hardly go lower), and we must hope that annuity providers follow suit. Reasons against doing so can always be found, though, such as regulatory requirements to hold extra capital.

The main source of good news over the past decade has been the development of the enhanced annuity market. The financial efficiency of conventional lifetime annuities has been traditionally derived from pooling of risk. Rates were based simply on age and gender; your state of health, where you lived, your occupation and other factors were disregarded. Cross-subsidisation meant that in a given age cohort, those who lived longer benefited from the early deaths of others.

I wrote that in the past tense deliberately, because the growth of enhanced annuities is steadily eroding the pool. We are on track, it seems, to individual underwriting. Whether that will arrive is a moot point; probably the additional cost will prove prohibitive. But why are enhanced annuities seen as a good thing? Simply because you get more for your money.

For example, if you're a heavy smoker your life expectancy is reduced, so the insurer can afford to pay you a larger amount per year in exchange for the lump sum you hand over when you buy an annuity. Annuities work in the opposite way to life assurance, where a heavy smoker will be charged more per year in exchange for the fixed lump sum the insurer hands over on death.

In the industry this is well-understood, but not necessarily by the public at large. The role of advice is crucial here: a good adviser will strive to identify any reason why the client might possibly qualify for an enhanced annuity. Even simply living in a heavily-industrialised locality might help. Some say it's a scandal that many people who deserve compensation in this form for their impaired life are missing out because they don't know what's available.

But what if you don't qualify? Here comes the bad news: the rate you get will be even lower than it would have been under the old system, before the pool was atomised. Nobody talks about this, although it might seem common sense that if some members of an age cohort are now to be paid more than what would have been an average in the past, others will receive less. The truth is easily concealed, though, with so many other factors involved in setting annuity rates.

There are good reasons for retaining the pooling principle. Bulk buying lowers unit costs, so group life assurance delivers lower premiums per life than can be bought by an individual. Workplace pension provision benefits from economies of scale and pooling of risk. Cross-subsidisation contributes to solidarity and societal cohesion, rather than every man for himself, and devil take the hindmost. The welfare state was founded on this principle.

Written by Ian Neale, director, Aries Pension & Insurance Systems Ltd

ian@ariespensions.co.uk