A new generation of products is set to spark a pensions bonanza, predicts John Moret
'Annuities ' the last bastion of insurance company conservatism'. That is a strapline that sticks in my memory from a series of intermediary roadshows I spoke at seven years ago. The roadshows were intended to launch a new type of annuity product ' the Flexible Annuity Portfolio. Unfortunately the Inland Revenue intervened at the last minute and decreed that the product wasn't an annuity - at least according to their rules. Their criteria for making this decision had never been published but broadly they said that an annuity must be 'safe, stable, regular and for life' and that the capital must be irrevocably transferred to the insurance company underwriting the annuity.
In recent months we've seen the emergence of a new generation of annuity products in the UK. These new products are built around greater flexibility in terms of income levels and underlying investments. They are a step forward but they still raise some fundamental questions. Is there still a requirement to choose the benefit structure at outset?
What happens if the choices made at outset prove to be inappropriate given changing personal circumstances eg death of a partner?
What flexibility of income is possible?
Will the annuitant be stuck with the one insurer for life? Is there any chance of switching if investment performance turns out to be a dog?
Perhaps the biggest issue with these new products is their complexity. It would be hard to describe them as either transparent or consumer friendly ' both of which are pre-requisites of this growing market. The demographic trends and industry statistics all point to a massive increase in demand for flexible retirement products. It is estimated that there is £300bn of funds accumulated in individual pension plans in the UK and with the likelihood of increased pensions savings (perhaps compulsorily) it is easy to see why the spotlight for advisers and product providers has moved.
The new 'open' annuity
Recently a new annuity product has been unveiled ' the 'open' annuity. Although full details are still unclear it appears to offer income flexibility with some investment freedom ' currently limited to collective investments. Instead of the normal mortality cross-subsidy ie early deaths subsidising the longer-living annuitants - the 'open annuitants' can achieve a full return of fund on death (subject to IHT in the normal way) by buying individual shares in the insurance company underwriting the product.
While these features are potentially very attractive it is too early to say whether the product will mark a watershed in the annuity compulsion debate. It certainly marks an encouraging trend towards simplification in this areas of the market ' albeit that the underlying structure is less clear than with comparable products. It will be interesting to see how it fares.
The creative juices have clearly started flowing in the UK annuity marketplace. This must be beneficial but is it the answer that the Government have been urging the industry to put forward? I think not. Alongside these product developments there have been some fascinating research documents prepared. The ABI paper 'Is there an annuity problem' attempts to provide a balanced argument. However comments such as 'The extent of the problems facing the existing options available for retirement income do appear to have been overplayed. Many are in reality problems in perception.....' are open to varying interpretation suggest to me that some pre-conceived ideas may still be dominant.
More recently the Pension Board of the Faculty and Institute of Actuaries produced an interesting extension to the annuity debate in the form of a paper called 'Extending Retirement Choices.' As the authors state their aim is 'to demonstrate that the key to better annuity provision is to offer more choice at retirement but to ensure that more of the options available increases the likelihood that reliance on State benefits will increase as a result. A worthy objective but hard to achieve.
In their paper they identify seven different customer needs which would be relevant to someone converting a retirement fund to retirement income. Few would argue that these needs, which are shown in table one are important.
That paper then goes on to assess the suitability of four retirement options against these needs. Table one shows a summary of the findings and is taken from the paper. The authors warn the table should not be read in isolation of the arguments that they advance in the text.
The really interesting part of the paper are the four options that are considered. Aside from traditional annuity contracts, the authors also examine the case for three other options. They look at the potential for use of deferred and temporary annuities alongside the traditional annuity. These are grouped under the heading 'More choices ' income approach'.
They assess the Choices Report produced last year by the Retirement Income Working Party chair Dr Oonagh McDonald. This Report introduced the ideas of a 'Minimum Retirement Income (MRI)'. On retirement an individual had to secure an index-linked pension from their pension fund of not less than the MRI. The basic state pension and other pension income would count towards this target. It was suggested that, provided the MRI was secured, more innovative methods for dealing with the residual fund could be found.
The drawback with the option proposed in the Choices report is the high cost of securing the MRI annuity. Since this would amount to around £50,000 for many individuals with smaller funds the practical impact would be little different from today's situation. It was this that led the authors to the fourth option - the Capital approach.
Under this option there would be no requirement to buy an annuity at outset - provided the fund was more than sufficient to secure the minimum specified level of income.
The retirement fund could be invested and income drawn from it until such time as only the MRI could be secured. The right level for the MRI is debated and left for further discussion. The practical issues with this option are significant but in as much that there is no immediate requirement to purchase an annuity and that purchase of dependents benefits could be delayed there appear to be some real advantages compared with the Choices option.
Brief consideration is given to the method of determining the point at which annuity purchase would be required. A key issues is the provision of better, regular and more meaningful information - the suggestion is to use a combined benefit statement which would be prepared and issued regularly by a PDP manager. PDP stands for Personal Distribution Plan ' the name that the authors have given to this new style of annuity option.
Ireland and Europe
There is more than a passing resemblance in the PDP to the relatively new retirement option arrangements in Ireland. Initial feedback on the new Irish regime suggests that it has been successful with strong growth in savings spurred by the ability to avoid purchasing an annuity. Apparently those with smaller funds continue normally to select an annuity.
Consideration of the new Irish regime leads onto the position in other European countries and elsewhere. The danger in looking at countries such as Australia, Chile and some of the more progressive European nations is that there are significant variations in key areas such as the political economy and the power of the end-consumer.
Although the implications of the demographics are similar ' an ageing population and reducing numbers to support them ' the severity of the problem varies. Annuity compulsion is exceptional although in many countries the traditional lifetime or temporary annuity remains a favoured choice for many of those retiring.
It is undoubtedly the irreversibility of the decision to purchase an annuity which is the biggest drawback to annuities. Table two is extracted from another research paper 'How should we insure longevity risk in Pensions and Social Security?' by the US expert Jeffrey R Brown. The paper looks at the impact for the USA of the continuing improvement in life expectancy for pensioners and suggests that one step is to introduce an element of compulsion. Table two is taken from this paper and explains why so few US pensioners purchase an annuity to provide their income in retirement.
US pension framework
While the US pension framework is very different from the UK, the reasons are, I suggest, very similar to those that would be put forward in the UK. What is clear from all these research and other proposals is that the annuity compulsion debate is complex and that the Government is probably right to delay taking any radical action until all the options have been explored. Encouragingly this issue, with which I have been personally involved for several years, is at long last being treated openly and seriously. That is only right and proper given the expected growth in maturing pension funds over the next two to three years. Hopefully the 'head in the sand' attitude which has dogged this area is now a thing of the past.
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