The plunge in stock markets has affected the take-up of investment-linked annuities as the risks in equities have starkly demonstrated but the sector still has its fans
Investment-linked annuities have been a hard sell over the past three years, amid falling stock markets which have led potential investors to turn their backs on equity markets.
Even so they have their backers who feel the contracts still have an important place in the UK market.
Danny Cox, pension specialist at Hargreaves Lansdown, says investment-linked products have a role among annuitants who are aiming for a potentially increasing income. Because of the high risk factor, it is necessary that they also have another form of income, he stresses.
'Without exception, people whose only source of income is their pension, should not be buying into investment-linked products,' he says.
He points out that the risk associated with these is demonstrated by the fact that anyone who had bought an investment- linked annuity in the past two years would almost certainly have seen a reduction in their income.
David Marlow, marketing manager at the Annuity Bureau, says taking the longer-term view, investment linked annuities have been well received. More recently, due to market volatility, there has been a greater nervousness among potential annuitants, leading to a decline in the take-up of these products.
Marlow estimates that about 15% of annuities sold are investment-linked annuities, incorporating both unit-linked and with-profits products.
'Investment-linked annuities were gaining market share overall. But in July, for example, when stock markets fell drastically, we experienced the highest take-up we have ever had on standard, guaranteed rate, annuities,' he says.
'I suspect this is a reflection of current market volatility. People have become more nervous about taking market risk. They are ultimately starting to appreciate that, despite low income rates, they are getting a lifetime guarantee with these products. Given the backdrop of what is happening with the stock markets, investment linked annuities seem to have less appeal.'
Similarly, Cox says around 10% of annuities sold by his company would be investment-linked. His company does not actively recommend with-profits funds, so all current sales relate to unit-linked products.
'In addition, investors are very nervous at the moment. This is demonstrated by the fact that investments into Isas have fallen. People take the same view with their annuity. They do not want to risk buying an investment-linked product. They prefer to go into something safe that will provide exactly what they set out to achieve. This is why the conventional annuity remains the most attractive option for many,' Cox adds.
Meanwhile, John V. Morgan, pension marketing manager at Legal & General estimates that a maximum of 15% of annuities sold by his group are dedicated to with-profits annuities. Legal & General does not provide unit-linked annuities but it has provided with-profits since 2000.
Investment-linked annuities started in the 1980s with the introduction of with-profits annuities first by Equitable Life, and then later by Prudential. In the late 1990s, investment linked annuities became available via a number of providers.
Now, Liverpool Victoria, Standard Life, Prudential, Legal & General, Friends Provident, GE Life, Norwich Union and Britannic Retirement Solutions are the main players in with-profits annuities.
Major players on the unit-linked front include Scottish Widows, Merchant Investors and Canada Life. Meanwhile, Challenger, the Australian financial services provider that recently entered the UK annuity market, plans to launch with-profits and unit-linked annuities during 2003.
In addition to the unit-linked and with-profits funds, a more specialised flexible annuity has entered the market. These are unit-linked, but offer the ability to convert to a standard annuity in the future.
Marlow says: 'These flexible products allow you to change the income amount that you are taking, the investment profile and, with certain restrictions, change some of the annuity assumptions that you are building in.'
For example Canada Life operates a contract called the Annuity Growth Account. That is reviewed on a five yearly basis. Subject to conditions, the annuitant can change from having a single life to a joint life arrangement, and vice versa, at regular five yearly review stages.
'This could be quite a useful feature, especially where, one of the lives involved has a shorter life expectancy. So you have more control and hopefully you will end up getting better value for money through that route,' Marlow says.
Who are investment annuities for
Investment-linked annuities are most suited to the bottom end of the drawdown market.
According to Cox, such an annuity is ideal for someone who does not have sufficient funds to go into drawdown although the same objectives apply. Someone entering drawdown would normally be going in because they wanted flexibility of income and because they wanted to achieve growth on their income. 'The issue is that an investment-linked product is not drawdown, and you are still buying an annuity. Often drawdown is done to defer buying an annuity,' he says.
Marlow agrees that investment-linked annuities are most suitable for the bottom end of the drawdown market, but says the age profile must also be considered.
'People with very small funds would not want to take investment risk. People with sizeable funds, £250,000 and above, would most likely opt for income drawdown. This is partially due to age profile. A lot of our drawdown customers are in their late 50s and early 60s, where the mortality drag on the income drawdown is a relatively low factor. As people get older, that mortality drag increases and makes the virtue of annuities stronger and stronger,' he says.
Mortality profit results in higher returns for annuitants who live longer as they benefit from annuitants who did not live as long and so did not regain the full value of their annuity. To compensate for this loss of mortality subsidy, pension drawdown has to achieve an extra investment return.
'At the moment, most people in drawdown are still relatively young as most would have gone into it in their late 50s or 60s and they haven't actually reached the point where they need to buy an annuity,' Marlow says.
Minimum investment for drawdown depends from provider to provider, but is often around £150,000. Some providers of investment-linked annuities will go down as low as £10,000 to £20,000.
Morgan estimates that the average value of L&G's with-profits annuity is around £50,000, after the tax free cash withdrawal is deducted.
Marlow says investment linked annuities play an important role in that they offer choice.
'Over the longer term, one would assume that an investment-linked annuity would pay a higher income than a standard annuity. The natural assumption is that there would be some reward for taking the risk,' he says.
'It is still quite early in the lifespan of these products to really demonstrate that. Despite this and the current volatility of equity markets, I expect investment-linked annuities to grow in market share over the long term.'
With-profits are coming in for plenty of criticism at the present and this has a knock-on effect on annuities based on the vehicle.
Legal & General's Morgan fears they have been caught up in the general flack about with-profits funds but still offer a viable alternative for annuitants.
His argument is that if markets are now near the bottom and are on course to recover, then this should lead to good bonuses for the future. Of course calling the direction of the stock markets is a punt and the outcome can not be guaranteed. He says because with-profits have the benefit of not only fixed interest but equities, and other asset classes such as property, the overall return, even with peaks and troughs, should outperform bonds.
With-profits annuity payouts centre on an assumed or anticipated bonus rate (ABR). The client picks the level at the outset of the contract. Assuming this is a 5% ABR and the declared with-profits bonus for the first year is 3% then in the second year of the contract the income will fall to compensate for the extra money taken in year one. If the declared rate is higher, say 6%, then this will provide extra income in the second year.
In effect the higher the ABR chosen the greater the risk that in the long term the rate may not be met.
Morgan concedes that one of the hazards is assuming a high ABR or projected future level of return at outset.
'Intermediaries need to assess whether they are going for the biggest initial payment, or whether they are opting realistically for a level at which bonuses can be expected to exceed, and therefore give their client an increasing payment,' Morgan says.
Cox feels it is dangerous to go into with-profits annuities at the moment.
'We have come across a lot of with-profits annuities, where the ABRs have been 5% or above. There are still advisers using 5% and above to recommend on these annuities. Suffice to say, this is too high as an assumed bonus rate, most people should be going to 3%-4%,' he says.
'Certainly clients who are going into with-profits annuities should not be going in with a bonus rate of 5% assumed, which I know a lot of advisers are recommending.'
Investment-linked annuities a tough sell in a bear market.
Don't buy investment-linked product if annuity is only source of income in retirement.
Up to 15% of all annuities sold are either with-profits or unit-linked.
Growing number of flexible and investment-linked products on market.
Average case size for L&G with-profits annuity is £50,000.
Beware of relying on too high an anticipated bonus rate on with-profits annuity.
The increase in minimum AE contributions has had little impact on opt-out rates - with cessations after April increasing by less than two percentage points, data from The Pensions Regulator (TPR) shows.
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