While money-back guarantees seem to be a simple way of returning unused capital after death, they will have to be taxed appropriately and could also lead to a 10% cost hike to compensate for opting out of the pool
For most people, a key driver for working is to look after our nearest and dearest. It is natural that we would want to feel they will be looked after when we die and so we make arrangements to pass on wealth in various ways. For many people nowadays, their pension is a significant asset and although the main object of an annuity is to provide an income for life in retirement, many people feel rather cheated by the way annuities operate and consider it unfair they cannot pass this wealth on.
When buying an annuity, it is possible to set up a survivor's pension and opt for a guarantee period. But although a five-year guarantee can be paid as a lump sum, a 10-year guarantee must be taken as continuing income. All in all, these benefits fall very far short of what the customer is looking for.
Through the decline of final salary schemes and the increased popularity of money purchase arrangements ' occupational and individual ' the number of annuitants is increasing all the time and will continue to increase into the future. This swell in numbers means that annuities are coming firmly under the popular spotlight. It is therefore hardly surprising that calls to allow a return of unused capital on death ' to offer a money-back guarantee ' are increasing all the time.
The time is now ripe for changes to annuities. In February this year, the Inland Revenue and DWP issued a joint consultation paper ' Modernising Annuities ' which included a section on the return of capital to annuitants' survivors. The Budget in April alluded to the possibility of quick change. Since then it has gone very quiet, however.
But we do have the awaited publication of the Government's Green Paper on pensions on the horizon. This paper is expected to propose ways of simplifying both DWP and Inland Revenue legislation. The Inland Revenue is also currently working on its own proposals for pension tax simplification in a review. We hope to see the Green Paper and the Revenue proposals in the autumn and it is highly likely that proposals for changes to annuities will be included.
Whatever the timetable for issuing these proposals, we do know that money-back guarantees on annuities are on the Government's agenda. This has been reinforced by discussions held with some providers over the summer and it fits with the development of more flexible annuity products by the Treasury.
Money-back guarantees would be quite simple to work in practice. With an annuity, the level of income is calculated from the amount of capital and rates based on life expectancy. Adding options such as attaching spouse's pension, and increases in payment obviously also affect the level of income provided.
Offering a money back guarantee would simply be another option available, like an attaching spouse's pension. Dependent on the flexibility required by customers this guarantee could be offered in various forms.
It would be possible to extend the concept of return of unpaid installments as a lump sum, which is currently offered under a five-year guarantee. This could be extended to a 10 or 15-year guarantee period on the horizon, and clearly the longer the guarantee period, the higher the cost.
And of course this could be extended to what we might call a full money back guarantee. This would mean that when the person died their estate would receive a return of their capital less the total annuity installments paid.
This could work in a similar way to the capital protection option offered by purchased life annuities. But if the person has lived to such an age that their installments have exhausted the original capital sum paid, no payment would be due.
It is of course already possible to achieve some form of capital protection on annuities at the moment. The individual can buy a whole of life policy or diminishing term assurance plan to sit alongside the annuity to provide a return of fund. This can be a simple and cost effective option. But it can create complications ' for example, there may well be the need for medical evidence. And, of course, form filling is never popular.
One key attraction of a money-back guarantee option on an annuity would therefore be the simplicity of a built-in facility. But there are two important implications of such a development to consider.
First, there is the question of the Inland Revenue's view on the returning fund. The Treasury treats pension annuities as earned income, so, of course, it would view a return of the fund as a loss of tax. It is likely therefore that if money-back guarantees were introduced, there would be an appropriate tax charge on the return of fund. We need look no further than the 35% tax charge on drawdown death benefits to see a likely parallel.
The other issue relates to how annuities work. Annuities are a pooled insurance product. The income level is calculated based on life expectancy and size of capital. If a person dies before their allotted time, then the unused capital returns to the pool to subsidise other annuitants' payments.
If a proportion of people take the option of money-back guarantees, then they will no longer participate in that pool, and therefore the overall cost of annuities will rise to some extent. At present, the cost of providing a five-year guarantee is not seen as significant. Extending the guarantee period to 10 or 15 years would mean some additional cost. And the cost would vary depending on whether the annuitant was a man or a woman.
Going for the full money back guarantee would clearly add the biggest additional cost. The first rough calculations of this cost however, have not put it at no more than about an additional 10% for a 65-year-old, and considerably lower for younger annuitants.
There is no doubt that the introduction of money-back guarantees would be a popular step forward. Recent research carried out by the ABI showed that just under half of those surveyed (47%) were in favour of the development.
However, a lower number ' one in five of people asked ' were prepared to accept a higher cost in return for a money-back guarantee. Perhaps it is not surprising that people would prefer to receive something for nothing.
The increase in costs is clearly something that would have to be explained and accepted. There is no such thing as a free lunch and expecting annuity providers to lose the benefit of cross-subsidies without making an alteration to the level of payment is not realistic.
However, it is also important to realise that people need choice. It is surely up to an individual to decide ' depending on his or her own circumstances ' whether he or she would like capital protection, and if he or she is willing to accept an additional cost.
And here of course we clearly see the need for advice. Advisers would have a key role in explaining the different options available and guiding clients to the right decision about whether some form of money back guarantee was right for them.
Annuities are not the most popular of products at the moment which is particularly unfortunate since people who have private sector schemes are, sooner or later, compelled to buy one.
There are probably three main reasons for this unpopularity. The first is that many people resent the compulsion to buy by age 75 at the latest and would prefer to have more of the type of freedom offered by drawdown, for example. Unfortunately unless and until the Revenue is prepared to move in this particular area, age 75 remains a stumbling block.
The second problem is the perception that annuities offer poor value for money. Due to a combination of low interest rates and longevity improvements the difficulty here is a difference between perception and reality. The reality is that, in the current environment, annuities are more expensive to provide than they were even a few years ago.
Indeed the FSA has recently made it clear that annuity providers need to take care to ensure that their assumptions are realistic and prudent in the light of longevity improvements.
The third difficulty in the minds of consumers is the idea that if you die early, the insurance company pockets the money. One way to combat this difficulty is to educate customers to understand that they are buying longevity insurance as well as lifetime income.
Another way forward is to realise that, for many customers, the complaint hides a genuine need. Money-back guarantees could help meet that need. We await the next stage of annuity developments with interest.
Many people feel cheated by the fact they cannot pass on annuity benefits to dependents after death.
It is therefore hardly surprising that calls to allow a return of unused capital on death are increasing all the time.
One key attraction of a money-back guarantee option on an annuity would be the simplicity of a built-in facility.
Start with customer requirements
To ensure creditworthiness assessments compliant
Avoid broad-brush strokes
Partner Insight: Introducing the Architas education series for clients.