In the battle against low rates on standard annuities, a number of solutions have been put forward. ...
In the battle against low rates on standard annuities, a number of solutions have been put forward. Various criticisms have also landed at the door. Most recently, annuities have been criticised for discriminating by sex why should the income payable to women be less than that for men?
Taking it a step further, couldn't all rates be the same, regardless of any factors? After all, it would make 'the system' a lot simpler. But would it be fairer?
Let us imagine this for a moment. An annuity provider pays the same income level to anyone of any age (and all with the same additional features and benefits, such as guarantee periods for example). By removing the individual criteria from the calculation, such as age and sex, the provider must make assumptions about how long it will have to pay annuity income, based on the average life expectancy of all lives.
So in effect, there is one giant risk pool from which the annuity income must be paid. Nice and simple, but, given average mortality, the older lives and women will drain more than 'their share' from the pool. That is, the older lives would be paid income based on a younger age, and would therefore be paid income at the expense of the younger lives, who received income based on an older age.
Or to put it another way, a universal cross subsidy would exist.
Of course, the operation of cross subsidies already exists in the current system. Those who die early provide income to those who live longer than expected.
Crucially though, the mortality cross subsidy is based on individual factors. That is, by segregating annuitants by age, sex and the optional extras they buy, a multitude of separate risk pools are effectively in operation.
As a consequence, income levels payable to each individual should be closer to those that could be calculated with hindsight and come closer to reflecting actual mortality. The cross subsidies are not universal, but instead, apply to smaller sub-groups. Or to put it another way, there are a multitude of separate risk pools.
Whether you think the universal or segregated risk pool system is fairer or not, is of course largely irrelevant now.
Apart from Protected Rights benefits in Personal Pensions, which must be provided on unisex rates, the multiple pool approach is well established and continues to develop. Personally, I am in favour of the multiple pool approach. To me, this is fairest because it attempts to pay everyone at a rate appropriate to his or her own draw on the pool.
Special rates annuities
Special Rates Annuities, including Impaired Life Annuities, have been built on this concept of separate risk pools. In addition to the normal criteria, providers of these annuities find out more about each individual, to estimate mortality more accurately. By assessing mortality with this additional personal information, the providers of these annuities have been able to pay higher rates of income to those with shorter than normal life expectancy.
As always, the terms and terminology can be confusing. This is simply a consequence of the development of these annuities being offered by separate organisations.
Not only do the separate providers approach it afresh, they usually aim to compete in a specific area. Hence, the names of the products vary.
While this can be confusing for clients and advisers alike, it should not be particularly off-putting.
In principle, they all operate in the same way income rates are dependent on individual assessments of life expectancy. We use the term 'Special Rates' to cover them all, including the following (not necessarily exhaustive) list:
Socio-economic: Higher income may be payable to those who have worked in manual occupations (and some others), and who live in certain areas of the country.
Smoker: Higher income may be payable to those who smoke more than 10 a day, and have done so for the last 10 years.
Enhanced: Higher income may be payable to those with certain medical conditions. Providers usually assess from the information given in the application form.
Impaired: As for enhanced, higher income may be payable to those with certain medical conditions, but providers will usually seek a GP's report or require a medical examination. Clearly, this process can take longer than for standard annuities.
In simple terms, the potential increase in income is higher the further down this list you go.
One point to remember: the higher income that may be possible with special rates annuities is due to the expected reduced life expectancy and not the quality of someone's life.
This may again seem unfair to some, but as annuity income is commercially defined, two people expected to live for the same time will be paid the same income, even if one of them suffers from a disabling, but not life-threatening, condition.
For enhanced and impaired life annuities, the conditions that will warrant income increases include:
l Heart attacks
l Very high blood pressure
l Most cancers
I should also point out that no provider has yet launched a 'worse-than standard-rates' annuity. No provider has specifically sought to pay less to those with above average life expectancy.
It isn't all good news though. Despite being around for a while now, special rates annuities have not been launched by all providers.
The majority still pay income rates based purely on age, sex and the optional benefits included.
As the acceptance and use of special rates annuities increases, these providers will be writing annuities for those people with average or above-average life expectancy.
The obvious knock-on effect of this must be reduced levels of income on standard annuities. This pricing change has, to some extent, probably already happened, but, given the overall fall in standard annuity rates over the last 10 years or so, it has not been that visible.
Given the principles at work, I believe we may see the use of genetic tests enter the market for annuities at some stage in the future. Although any assessment of life expectancy would continue to be based primarily on actual health conditions, it is conceivable that a genetic disorder could give rise to increased income.
Finally, taking the multiple pool approach to its logical conclusion, there would be products with no cross subsidies at all. That is, a separate risk pool would be set up for each individual.
We have this already with drawdown pensions (where, following my use of terminology through, we might describe it as a 'private pool').
Just remember though, the Capital Taxes Office may look closely at drawdown cases written for those who are terminally ill and expected to die in the very short term, where the motivation for the product selection was death benefits.
Although probably an overestimate, one provider believes that as many as 40% of annuitants could qualify for a special rate annuity.
As annuitants can get significant increases in lifetime income, and despite the potential extra work and time they can need, they should therefore be considered for all those who may qualify.
David Marlow is head of marketing at the Annuity Bureau
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