Vince Smith-Hughes examines changing times for the annuity market.
The two main factors affecting the pricing of conventional annuities are the investment return on corporate bonds and how long the client is expected to live, together with how much to charge for the guarantee. These are all influenced by changes in the market and by regulation.
The implications of Solvency II are also already having an impact and this, combined with increased longevity, means it’s possible that guaranteed annuities will become more expensive to buy in the future. But by how much? Well, that’s a much more difficult question to answer.
Solvency II is forthcoming European legislation that includes the development of a risk-based economic framework for insurers, and one of the possible outcomes is that it may lead to lower annuity rates.
Some commentators have suggested rates may fall by between 10 and 20%, based on the picture that has emerged previously. The situation will continue to evolve, with lobbying and political debate in the UK and Europe, but at the moment the eventual outcomes are uncertain. While several different scenarios are being assessed currently, what is certain is that this debate will continue throughout 2010 and into 2011.
The date for implementation of Solvency II has now been put back to 1 January 2013. The change to annuity rates already appears to be partially factored into the annuity rates market, though there may be further to go.
The age 75 rule
After the Budget statement in June, there was a lot of noise about the Chancellor having abolished the so-called ‘compulsory annuitisation at age 75’ rule. Although, strictly speaking, this ‘rule’ already no longer exists, the reality is that the options for flexibility about how income can be taken are limited.
The Government has now published its consultation paper on removing the ‘age 75 rule’. This paper seeks to provide greater flexibility about how income can be taken, while protecting a key pillar of pension saving – that savings are used to provide a retirement income.
The paper recognises that for most people annuities will remain the best way to provide their income in retirement. However, it also allows greater flexibility about how and when income can be taken, especially where a minimum income level has been secured. Clearly this will be an area of great interest for advisers and for retirement income providers.
Undoubtedly there are areas where it will be important to get the details right, especially in respect of the minimum income requirement, and these are likely to provide much discussion and debate over the next few weeks and months.
Ultimately though, given that the effects of mortality drag start to bite significantly from 75 onwards, it seems likely that for many the question will remain ‘when to annuitise’ not ‘whether to annuitise‘. While some will certainly never want to buy an annuity these are likely to be a small minority.
For investment-linked annuities the main factors are the asset-backed investment return and how long the client is expected to live. These arrangements are less sensitive to bond yield movements and will also be affected less by Solvency II.
From an advice perspective this has the potential to make investment-linked annuities an attractive option to individuals about to retire. Though underwriting in the annuity market is becoming more client specific it is not uncommon to find the required yield to match an equivalent conventional annuity is around 4% per cent a year or even lower, which customers who have an appetite for some investment risk are able to consider. Many clients are also prepared to take on some additional risk and take an even higher level of income than this. Although the increased risk needs to be fully considered this is understandable because, quite often, new retirees will still be young and active and will potentially require more income than later in life. Most investment-linked annuities cater for this by providing the facility to scale back income at a later date.
One additional advantage of investment-linked annuities is that they can help spread the risk to the annuitant. For example by accepting an element of investment risk, the member has the potential to have an increasing income and therefore reduce the inflation risk which clearly wouldn’t have been the case had they bought a level annuity. It may also be that a higher level of starting income could allow the retiree to build in an element of spouse’s pension, which they simply couldn’t have afforded by using a conventional annuity.
The winds of change
Given the current economic outlook combined with forthcoming changes such as Solvency II many experts are predicting a move away from conventional annuities. Investment-linked annuities provide an interesting alternative as do other options such as fixed-term annuities, short-term annuities and drawdown with an element of guarantee. The change has already started, and advisers should ensure their processes include all the options.
Vince Smith-Hughes is head of business development – pensions at Prudential
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