George Osborne’s annuity reform plans are great news for future retirees.
But shareholders in life companies and annuity specialists aren’t happy. The share price of one annuity firm has fallen by 61% since the Budget.
I can understand why many investors are gloomy. The annuity market is undoubtedly going to shrink a lot.
But I suspect that the pessimism is overdone. And that means there are opportunities here for contrarian bargain hunters…
The annuities market is going to shrink massively
I want to focus on the two biggest post-Budget casualties: Partnership Assurance (LSE: PA) and Just Retirement (LSE: JRG).
Partnership closed last night at 124p, down from 319p before the Budget, while Just Retirement closed at 145p, down from 267p.
Both companies focus on providing annuities – in particular, annuities for people with health or lifestyle issues. So if, for example, you’re a diabetic and you retired last year, there’s a strong chance that Partnership or Just Retirement would have offered you the best annuity deal in 2013.
As I said immediately after the Budget, I see both companies as ‘good guys’ in this industry. Until now, the large life assurance companies have made big profits by offering poor annuity deals to customers who already had pension pots with them. Sadly, too many customers didn’t realise they had the right to shop around and get better annuities elsewhere.
However, Just Retirement and Partnership aren’t big pension companies. That means that all of their customers have already ‘shopped around’, and as a result signed up for market-leading annuities.
A fair proportion of these customers have had serious illnesses such as cancer. Others have ‘lifestyle’ issues such as smoking or heavy drinking. (If you’re a smoker, you’re more likely to die young, hence annuity providers are able and willing to offer you a higher income.)
So are these businesses finished, as the collapse in their share prices suggests?
They certainly face major challenges, no doubt about it.
They’re in a market that will inevitably get a lot smaller – one analyst has suggested the UK annuity market will shrink by as much as 90%.
And you could argue that the poor health/lifestyle part of the market may contract by even more. After all, if someone is seriously ill, will they really want an annuity? Wouldn’t they rather just spend some of their pension pot before they die and then pass the rest onto their family?
A second challenge is ‘adverse selection’. Even though annuity rates are already very low, average rates across the market may fall even more thanks to Osborne’s changes. The people who are most likely to buy an annuity in the future are those with a long life expectancy (or incorrigible optimists), so long-lived annuity buyers may no longer be subsidised by those who die soon after purchase, making it even harder to offer decent rates.
That’s the theory anyway.
But the annuities market isn’t going to die out altogether
However, even with these challenges, I’m pretty confident that Just Retirement and Partnership will still be able to win at least some new business.
Remember that all new retirees will now be offered free financial advice at the point of retirement. So that means all potential annuity buyers should be told about the best possible annuity deal for them (see my colleague Merryn Somerset Webb’s blog for why this is important).
Granted, many retirees will balk at any suggestion of an annuity. But I think some folk will be persuaded. Only an annuity can provide you with guaranteed financial security until you die, which is not to be sniffed at.
Just look at the US. Annuities have never been compulsory across the pond, but, as Lex pointed out in the FT yesterday, annuities worth $220bn were sold in the US in 2012.
It’s also worth noting that cancer patients often live for a lot longer than originally expected. If you can survive the first five years after you’re diagnosed, you may go on and live for another 20 years. And, of course, many smokers or overweight folk still live into their 80s or 90s. Many advisers will make all of these points to new retirees.
Then there’s the issue of gilt yields. Annuity rates are closely linked to long-term gilt yields. Currently gilt yields are extremely low. But they will inevitably rise sooner or later and when that happens, annuity rates should rise too, making them more attractive.
So I suspect that advisers will persuade some people with health/lifestyle issues that buying an annuity is still the best option. That will provide Partnership and Just Retirement with some new business.
These companies will also continue to make money from their existing annuity books – as long as they’re able to invest the capital from their existing annuities shrewdly.
So both companies will still receive premiums from any new annuities they sell, and profit from their existing books. Just Retirement will also generate income from its equity release products.
Don’t get me wrong – Osborne’s move, while good for savers, is unequivocally bad news for the annuities industry. I accept that the annuity market will contract significantly. I just doubt that it will be by as much as 90%. And I think the poor health/lifestyle end of the market will survive too.
Which one should you take a punt on?
When you look at valuation, Partnership looks cheaper. It’s on a historic price/earnings (p/e) ratio of five, while Just Retirement is on a p/e of 12.
I think there are two reasons for that differential. Just Retirement has a sizeable equity release business, and it’s also less exposed to the ‘impaired’ annuity sector where you’re selling annuities to people with serious conditions who may die within a year or two.
However, of the two, I’m most drawn to Partnership. On a p/e of five, I think it has the potential for a ‘dead cat bounce’ at the very least. And over the longer term, I think the company can still make money from annuities. So it could prove to be a decent, if risky, investment.
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