Helen Morrissey assesses the difficulties currently being faced by the variable annuity market and asks how it will develop going forward
Variable annuities have endured a turbulent time since they were first launched into the UK at-retirement market more than two years ago. While the initial concept of offering the opportunity to gain market upside while benefiting from guarantees seems sound, these products have also been dogged by criticism from those who dub the products as expensive and overly complicated. The majority of variable annuity providers were US players and it was hoped that the entrance of a big UK player would do much to improve competition and really open up the UK variable annuity market on a grand scale. Standard Life and Prudential were both very much in the frame to be the first UK-based provider to enter the market but when Standard Life first delayed and then cancelled the launch of their product it led many in the industry to question what direction this market was taking.
Further bad news was to come in May when The Hartford, one of the best known variable annuity providers withdrew from the UK market and it was closely followed by Aegon Scottish Equitable who announced plans to launch a product to supersede its 5 for Life product. The rising cost of providing the guarantee was given as a reason for these moves with the providers citing the current inclement financial conditions as the reason why. So where does the variable annuity market go from here? What are the key challenges that it faces and how can they adapt?
Lack of understanding
"The problem with variable annuities was that the public and even most IFAs and trustees do not fully understand the complexities of variable annuities and even the retirement income market as a whole," says Rockingham Retirement managing director Steve Hunt. "Unfortunately, I don't see this situation changing until there is new legislation, such as that seen in the Pension Review of the late 90s that we will see greater understanding of these disciplines."
However, not everyone agrees that the concept of variable annuities is overly complicated. According to Aegon spokesperson Mark Locke, most customers don't need to know the mechanics of how variable annuities work.
"I wouldn't agree that variable annuities are overly complex," he says. "I don't need to know how an internal combustion engine works - I just need to know that it will get me from A to B. I don't need to know the finer details. Over time people will get to grips with these products and the providers have teams of experts to help advisers with any queries."
Prudential's annuity and solutions delivery director Karin Brown agrees with Hunt that variable annuities are complicated but believes that the market can overcome these challenges.
"Variable annuities have faced many issues and even the name has done little to help them," she says. "To begin with, most of the products that were tagged as variable annuities weren't even annuities, and this confusion has done little to help the market. However, they do meet a customer need and we will expect to see this market strengthen going forward and it will adapt to market conditions. We also need a price that works for the customer and backed by the financial strength of providers."
It's also worth pointing out that when variable annuities were launched the market was very different to what it is today. Variable annuities were developed during stable environments and have been severely stress tested over the past year.
Locke explains the changing conditions are the key factor behind Aegon's decision to develop the Aegon Secure Lifetime Income product to replace its current 5 for Life offering at the end of June.
"We are launching a product that supersedes our current 5 for Life offering," he says. "Those already in the 5 for Life contract will stay in it, whereas new customers will go into the new product. The Aegon Secure Lifetime Income product offers guarantees that are age appropriate and balance out current market conditions. When we launched 5 for Life in 2006 the market conditions were very different from those we are in now and the guarantees offered are dependent on interest rates and market volatility. Back in 2006, we were looking at interest rates of 5.5% whereas now the interest rates currently stand at.5% - it's a huge difference. The investment market is also much more volatile which increased the risk of the client needing to rely on the guarantee."
The way forward
So it is clear that variable annuity providers are facing many challenges as they seek to embed these products in the UK marketplace. While they have had a difficult time, there are still some encouraging signs. A recent Watson Wyatt survey showed strong sales growth for variable annuity products in the first quarter of 2009. Variable annuity product premiums were recorded as being £370 million for Q1 2009 - a 7.7% increase on the previous quarter. It's also worth noting that variable annuity business topped the £1 billion mark for the first time at the end of 2008. Could this be a sign that advisers are finally getting to grips with these products and that the educational programmes being run by the providers are starting to finally pay off?
"We've been running a series of unit linked guarantee workshops to explain the client need and how guarantees work," says MetLife UK managing director Dominic Grinstead. "We understand there is a need to simplify the product and ensure advisers understand it and we are seeing a big increase in adviser levels of understanding and comfort for these products. As a result we see a big future for them."
Locke agrees, saying that while the market is experiencing difficulties at the moment there remains a long term demand for these products.
"While there has been upheaval, research from Watson Wyatt demonstrates that this is a growing market," he says. "Customer need doesn't go away over night. The Hartford has chosen to go back and concentrate on its core business but they were still selling a lot of variable annuities. I would actually envisage more product providers coming into this space."
So while many incumbent providers insist there is a role for variable annuities going forward, what of those who considered entering the market and then didn't? According to Standard Life's senior pension policy manager Andrew Tully, the concept of variable annuities is interesting but developing a product that is reasonably priced is proving difficult right now.
"As a concept, it is undoubtedly still of use as there is a strong customer need for more flexibility," he says. "At the moment, the offerings available at retirement are extreme and there is a need for an option that occupies the middle ground. The research we did into variable annuities demonstrates that people like the guarantee that comes with an annuity but don't like the lack of flexibility. With USP people like the death benefits and flexibility but the risks associated are too high for many. People ideally want a product that provides a guarantee but also the possibility for some investment upside and this is what variable annuities aim to provide. At the moment, the issue the industry faces is being able to design a viable product that gives clients what they want at a price they are willing to pay."
Brown agrees, saying that Prudential looked closely at variable annuities as part of its overall retirement offering, but current conditions have made it difficult to develop a reasonably priced product.
"As you would expect we offer a range of at-retirement products and we did look closely at the variable annuity market but the economics of it just didn't work at the time," she says. "However, customers do still need income with guarantees and we will continue to explore all the choices available and see where we can provide more choice."
So it would seem that providers still feel there is a place for variable annuities going forward but that current market conditions are making it difficult to expand. Standard Life's Tully says he expects the variable annuities to not "be used extensively for the next year or two", but that when the market settles down he expects providers to revisit their options and possibly enter the market.
MetLife's Grinstead is also positive about the future of these products and believes the burgeoning defined contribution market could provide more growth.
"At the moment, our average case size is about £130,000 but I can see more options being developed for those in the £25,000-75,000 category," he says. "As the defined benefit market contracts and we see DC pot sizes grow l think we will see a need for a variable annuity in this space. I am very positive about the prospects for variable annuities and I do think we will see more competition coming into the market as other providers look to develop products."
So it looks like we will be seeing variable annuities for some time to come and those who develop robust, well priced products will prosper. However, according to Rockingham's Hunt, increased education will be paramount, not just for the success of variable annuities but for the at-retirement market as a whole.
"We need to take a Darwinist approach - Survival of the fittest," he says. "No educated and informed person today would buy a conventional annuity; it will take a long time for this message to get through and it will not be until a lot of 'blood has been shed' i.e. a lot of people mis-sold and suffering the consequences that anything will happen I fear!"
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