If you fail to check out things like overall value and death benefits when choosing an annuity, you could be taking a giant leap, says Peter Carter
Never has so much been said about annuities and their future than in the last three years. Brought about by plummeting interest rates and improving mortality, the industry and consumer groups are desperately searching for alternatives that will address the shortcomings of annuities as they are now perceived.
The Government has already introduced legislation to allow drawdown from personal pensions and this has greatly improved the scene for those wanting to take benefits from their pension funds. Drawdown favours the individual with the larger pension fund as the costs and risks associated with this type of plan are greater than the standard annuity.
Product development in the annuity field has been frenetic over the past couple of years, with company after company launching their version of the with-profit annuity. So never let it be said that insurance companies are not rising to the challenge of addressing some of the deficiencies of annuities as seen by advisers and consumers. If the industry has not come up with the answer it is not for lack of innovation, but rather that the rules the Revenue imposes on providers lead to the types of structures we see in the marketplace today.
My own experience of this market leads me to suggest that the main issues for consumers are those of the overall value of the benefit they receive (the annuity rate) and the amount of death benefits that the product is likely to give their dependants. Annuities do give reasonable value for policyholders in terms of a guaranteed level of income for the rest of their life.
The issue for the industry is communicating the value of the guarantee to customers in a way that they can understand. Annuity income has advantages over income from other forms of investment, as its level is not going to fall.
However, this advantage is lost in the concern about death benefits and the historically low levels of interest rates. In terms of death benefits, the obvious disadvantage is again that a client can buy an annuity one day and die the next ' the greedy insurance company profiting from the pension fund. The flipside of this argument is that the person that lives to age 100 has received significantly more than the insurance company bargained for when the rates were calculated. In effect, those people that die early subsidise those that live longer.
As mentioned earlier, the reason that all annuity products have these features is all to do with what the Inland Revenue accept as an annuity. Their two golden rules are:
l An exchange of capital for income
l Pooling of mortality interest among annuitants
Where we have seen some movement from the Revenue is that the exchange of capital for income can now be of a level determined by investment returns ' hence the popularity of investment linked annuities such as with-profits. Where there has been absolutely no movement is in the pooling of mortality interest, and it is this crucial area that leads to the poor death benefits that annuities are said to have.
If those that die earlier subsidise those that live longer, it is clearly impossible to return the fund on death as this is the source of the subsidy. This is what makes drawdown different from an annuity. As there is no subsidy, there is a lump sum death benefit. The 'downside' of drawdown is that as the client gets older, the lack of subsidy shows itself in the higher growth rates required from a drawdown plan to match the income of an annuity. This can be significant and could account for an additional growth requirement from the fund of 4% per annum for people in their seventies.
My own belief is that annuities will continue to play a key part in retirement planning. And this includes all the various types on offer today ' fixed and investment linked for example. For many, they form the bedrock of a sound income stream, which, along with income from other investments, can provide a reasonable standard of living in retirement.
In terms of new product developments, expect to see further initiatives along the lines of those offered by Canada Life and Prudential. But don't expect anything more earth shattering than these types of products until the Inland Revenue reviews its rules as to what constitutes an annuity.
What you can expect is more products offering access to equity-style returns within the confines of an annuity wrapper. This gets over one of the key issues of value for money that has been laid at annuities' door, in that although the income may be variable, returns from investments have historically outstripped those from fixed interest assets on which conventional annuities returns are based.
A proposal often put to me is to run a protection product alongside the annuity in order to provide a death benefit for the policyholder's beneficiaries. The problem with this is that the cost of the protection mirrors the mortality subsidy that the annuity provides.
You therefore end up with a product that looks more like a drawdown product in that the amount of income available is reduced by the cost of the life cover. The income would be similar to a drawdown plan.
So how does the market look for those with the 'at retirement' decision to make? In my view, it breaks down into three broad areas depending on the client's attitude to risk and the size of their pension fund (see diagram).
The larger pension funds with clients who understand the risks (including mortality drag) of drawdown will no doubt go down the first route. This is generally assumed to be those with £250,000 in their pension fund.
The next tier down is for those who have a reasonably sized pension fund and probably have a more balanced approach to risk. This really is the mass market and will be an increasing segment as those with money purchase pension funds come to take their retirement benefits. They will choose investment linked of one type or another. Although this part of the market is mainly aimed at those who have moderate pension funds (£50,000-£250,000), there is a degree of overlap with many splitting pension funds between drawdown and investment-linked annuities.
Indeed, those who are not concerned with death benefits and want the maximum income may have large funds that will be invested in investment-linked annuities of the order of £250,000 to £500,000.
Probably the largest market is for annuities backed by fixed interest securities. For the risk averse, these are ideal with their absolute guarantee of the level of income. The pension funds for which these are most appropriate are anything up to £100,000. It is difficult to be definite in this market, however, as many people will still want the guarantee of a fixed annuity and may invest large sums of money.
So the market is developing more rapidly now than at any time before. But people should not expect any dramatic change in pension legislation that affects annuities after Labour won the recent election. Even an increase in the annuity purchase date from 75 will have to be fought for.
• Groups are searching for solutions to the perceived shortcomings of annuities.
• The main issues for consumers should be the annuity rate and the death benefits.
• With the re-election of Labour, major changes to the annuity system look unlikely.
Three years at Wells Fargo
Effective from 9 December 2019
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Continuing the Architas education series for clients.
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