The annuity market isn't perfect but Colin Bell, product director unit-linked guarantees at Aegon considers alternative solutions..
Falling retirement incomes are dominating industry discussion more than ever, it seems.
Pensions Minister Steve Webb's suggestion to introduce switchable annuities has drawn criticism from experts. Whatever your take on Webb's proposal, the annuity market is in desperate need of an overhaul.
The proposals from the minister are based on two main lines of thinking: first, retirees fail to shop around or seek advice and, as a result, miss out on the best deal in the market.
Secondly, if people get a mortgage, they are allowed to switch, whilst an annuity is set in stone once purchased.
The insurance industry scoffed at the latter idea claiming his proposal was too simplistic. They argued that an annuity is calculated on a number of factors and is not as straightforward as, say, a fixed term mortgage calculation.
Purchasing an annuity means buying a guaranteed income for life and enabling people to switch mid-term could introduce another (detrimental) variable to an already complex calculation.
Annuities remain a popular retirement income choice with many people welcoming the certainty the product gives them. Statistics show some 400,000 annuities are sold every year with this figure expected to double over the next few years.
However, the industry has long been accused of not providing enough easy-to-understand product information for customers. One of the main sticking points seems to be that many still lack a basic understanding of how annuities work; i.e. that they are pooled risk investments and rates are affected by yields on the long-term investments that insurers use to back their guarantees, along with life expectancy indications.
The traditional model for longevity insurance is based on pooled risk of healthy as well as unhealthy annuitants. This spreads the individual risk of money running out in retirement - but arguably gives a poor deal to the unhealthier lives.
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In practice, since the advent of smoker rates by Stalwart in the mid-1990s, this unfairness has been diluted by further moves towards individual underwriting through the development of postcode and enhanced/impaired annuities.
Retirees with demonstrably worse prospects can get better rates, but it still requires them to recognise their position; know that better rates are available, and make the effort to obtain them - a tall order, particularly without advice if they have a small retirement pot.
Arguably, the industry needs to do more to ensure people in this position get the best deal possible.
For ‘standard' healthy annuitants, 20 years of declining bond yields, compounded by quantitative easing, plus continual improvements in life expectancy have left rates looking unattractive. Whether or not they still represent a good deal for this segment, based on their improved life expectancy, is lost in the fog of perception.
Taking out an annuity might still be the best financial route to take for many but it's not the only solution. In 1975, the Open Market Option was introduced allowing customers to buy their annuity from a different provider. However, there are alternatives available which are often overlooked simply because people didn't explore all options available to them.
The Association for British Insurers recently revealed that 52.1% of people who bought an annuity in 2013 had not taken advice. The industry has already launched a review - A New Retirement - to explore changes that could be made to help people get good outcomes in retirement.
Drawdown is seen as an increasingly attractive option for healthy lives with bigger retirement pots left looking at what they see as poor annuity rates. Here, investors set aside the relative inflexibility but certainty of the risk-pooled traditional annuity and take on the full mortality and investment risk themselves.
However, for many cautious retirees, this may be too much risk to bear when they are really looking forward to a stress-free retirement.
Unit-linked guarantees of lifetime income, a relatively new option, are often overlooked but these can be a very useful ‘halfway house' between annuities and drawdown, giving underlying guarantees but also flexibility and growth potential and the potential to pass on remaining funds to their heirs on death.
They can be tailored to a person's specific level of risk in terms of investment and income needs. Investors can also exercise choice depending on their changing life circumstances. Whatever the choice might be, there is a guaranteed income for life on which the investor can rely.
With this in mind, it could be argued that Webb's revolutionary idea already exists; these unit-linked guaranteed products offer a minimum guaranteed level of future lifetime income but also flexibility. There are of course charges that apply and any product that offers a guarantee comes at an added cost - much like the insurance premiums payable on household contents - and that cost depends on the guarantees chosen and the fund(s) invested in.
Looking at all the options for retirement income provision (and potentially combinations of these) one thing is clear; the market is already wide-ranging, flexible and competitive but is also complex.
There is a real need for advice and guidance across all the options. Retirees with bigger pension pots will have access to such advice ensuring they get the deal most suitable to them. However, from my point of view, the issue lies with smaller pension pots and the industry needs to find to provide further guidance to those retirees.
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