Now and again governments make seemingly routine announcements that turn out to have enormous consequences. Whilst it is early days, it is likely that one such event occurred at the last budget, when the Chancellor announced that the compulsory purchase of annuities is to be abolished. That statement attracted a great deal of attention at the time from the financial press but it is probable that it will have much larger consequences for the economy as a whole.

An annuity is a promise from an institution, the annuity provider, to pay an income for life to someone who invests their pension fund, but the investor no longer owns or controls the capital invested. The provider doesn’t however know how long the investor will live, or what capital markets will offer as income over that period. It can generally do two things to reduce its risk when calculating the level of income it can pay. Its actuaries can make an informed calculation on the investor’s likely longevity, which will give a fair idea of how long its liability will last. It can also guarantee an income stream by buying gilts that match the expected lifespan of the investor, the income from which, together with the gradual return of capital, will constitute the cash flow it pays as an annuity.

Although annuities have been around for a long time it is only in recent years that they have become of interest to the general population. The gradual demise of workplace pensions that promised a defined annual payment based on years of service is now a rare and precious thing. Increasing average life expectancy and the unwillingness of companies to write a blank cheque to cover an unknown liability has effectively killed them off.

Instead the responsibility has been increasingly transferred to individuals to make their own arrangements, by saving enough money in a fund to buy their own pension, an annuity, at retirement. The scale of the task should not be underestimated. One way of quantifying the challenge is to look at the typical value of civil servant pensions from the Government Actuaries Department, which estimates that, for example, a 50 year old policeman has a pension pot equivalent to £600,000. To buy an income of £7,000/pa a healthy 65 year old single male needs about £100,000. The reason the annual income is so…

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