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27 March 2014 last updated
UK annuity rates unchanged by Fed tapering but interest rates will bite

The US Federal Reserve reduces the stimulus package by a further $10 billion with UK annuity rates remaining the same with little movement in gilt yields as markets already expect an end to the stimulus.

Annuity rates are mainly based on the 15-year gilt yields and as a general rule a 10 basis point move in yields will result in a 1% change in rates.

In the US the stimulus package was started in September 2012 and designed to buy $85 billion of bonds and mortgage debt per month allowing investors to realise higher returns in other assets, such as equities.

This has also helped to lower long term interest rates which has contributed to the improvement in economic growth.

As the stimulus reduces there is less demand for bonds and gilts lowering the price and increasing yields, however, even though the buying has now reduced to $55 billion per month it has had little impact on yields and annuity rates have remained unchanged.

 
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Interest rate rise likely in 2015

Market focus is likely to shift from tapering stimulus to interest rate rises and this is expected to occur from the spring of 2015. The stimulus was at $85 billion in December 2013 reducing by $10 billion in January 2014 to $75 billion, another $10 billion reduction in February to $65 billion and the latest $10 billion to $55 billion in March.

Chairman of the Federal Reserve Janet Yellen has stated that the tapering is likely to continue at this rate so the asset purchase programme (stimulus) will end at the end of 2014. The first increase in the Federal Funds Rate or interest rate will occur about six months after this time.

A change in interest rates will result in yields increasing for bonds and gilts so it is likely that changes will occur from spring 2015 and pension annuity rates rising shortly afterwards. Until then it is likely that interest rates will remain low in the US and UK.

Original the Fed had stated that interest rates would rise when unemployment reached 6.5% a figure set in December 2012 and it is currently 6.7% in the US. This condition has now been removed giving the Fed more flexibility for the start of higher interest rates.

In the UK the Bank of England is likely to raise interest rates from 0.5% to 1% during 2015 and then to 2% by the end of 2016.

Impact of interest rate rise on annuities

A rise of 0.5% in interest rates is likely to see yields higher by 50 basis points and annuities up by 5% by the middle of 2015 and with interest rates at 2% yields will be higher by 150 basis points and rates up 15% by the end of 2016.

For example by the end of 2016, our benchmark is for a person aged 65 with a fund of £100,000 buying a single life, level annuity of £6,093 pa now. With the improvement in annuity rates this would result in an increase of £913 pa to an income of £7,006 pa.

In terms of lifetime income, the Office of National Statistics (ONS) would expect a male to live for 17.3 years and he will have £15,794 more over his lifetime. For a female she can expected to live for 20.4 years increasing her income by £18,625.

In practice there would be a cost of delay to wait two years for this improved income although a fixed term plan would allow for an income to be taken now and a guaranteed fund at the end of the term used to purchase a lifetime annuity.

A fixed term plan is written under capped drawdown rules so does not commit a person to an annuity and the fund at the end of the term can benefit from the government's new pension proposals where an additional cash amount can be taken less tax at a marginal rate, a lifetime annuity or another fixed term plan from any provider for the ultimate degree of flexibility.

News related stories:
Best annuities to benefit if US Federal Reserve tapers stimulus
UK annuities could rise as market expects Fed to taper stimulus
Annuity Rates stabilise as US Fed delays tapering stimulus
Related internet links:
Forbes - On target to raise interest rates in spring 2015
Guardian - Fed axes another $10 billion from stimulus
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