Webb’s annuities dream could become reality

As the Liberal Democrat minister for pensions, Mr Webb has enjoyed a very high-profile year in the wake of chancellor George Osborne’s pension freedom bombshell which announced the removal of the need to buy an annuity at retirement. Mr Webb’s latest idea is that these freedoms should be extended to all pensioners, including those who already have a pension in payment, enabling them to sell their annuities and receive cash. This article looks at some of the aspects of this proposal, which Mr Webb claims has been warmly received by the insurance industry, and whether we will see the creation of a new market in “second-hand annuities”.

The essence of the idea is that all pensioners in receipt of a pension will be able to sell their future income in return for a lump sum. Mr Webb has speculated that this could lead to the establishment of a wider market in “second-hand” annuities.

This idea has some sort of precedent in the second-hand endowment market which developed during the 1980s and 1990s. Here the market grew as market makers saw an opportunity to buy endowments – mostly with profits – from policyholders dissatisfied with the potential surrender value quoted by their insurance company. The market grew as it offered a more attractive payment to the policyholder while offering a reasonable return from the ultimate proceeds of the policy –particularly as with profits payouts increased fairly steadily during the 1980s and 1990s.

First, let us make it clear that a lot of legislative and tax changes would have to be made in order to make this idea a reality – we will return to these later. Essentially, a policyholder who was receiving a regular income from an insurance company or a previous employer could go to the market and see what price he or she could get for the future stream of income. Having agreed a price, the pensioner would assign these payments to the new owner to be received while the policyholder remained alive – exactly in accordance with the terms of the original agreement.

The cynical view is that insurers believe they can pick up some assets at a cheap price. For example the company or provider which is making the payments to the pensioner might think it can recapture the contract for a price lower than it has valued it in its books. This would lead to a profit or at least a release of the provisions held against the future payments.

Perhaps more obviously though, the insurance company that bought the contract would be in receipt of regular payments which would depend upon the life expectancy of the policyholder – as such it would have an asset which was clearly closely aligned with its own obligations to pay its pensioners.

Another reason could be that the industry believes that the process will give them more accurate information about the lives they are underwriting and the state of their health. If you think about the current system, an insurance company has a great deal of information about the pensioner at the point he decides to retire – information about health, lifestyle, place of residence, marital status and so on. After five years this information will be less relevant and after 10 years it may be completely misleading. Mr Webb’s market could give access to a lot more information about the health and most importantly the likely longevity of the pensioner, enabling insurers to more accurately assess the lifetime cost of the pension.

So is this also a good idea for pensioners then? It looks to us as if the answer to that is yes and no. There may be categories of pensioner for whom this is great news. Perhaps those who only had small pots of insured pension money who, up until the last Budget, were forced to take an annuity for very small amounts of income. I think there may be a win-win situation here to “cash in” the annuity with the existing pension provider – the pensioner gets a (smaller) pot of cash and the insurer no longer has to administer what may be very small monthly or annual payments and can make administrative savings.

Another group that may do well out of this are the healthy pensioners whom the market may expect to enjoy a longer than average life – they may be offered quite attractive terms to sell their future pension payments. Then there may be some who took out annuities when interest rates were higher and expectations about longevity were more modest. For example at the start of 2008, seven years ago, pensioners got a relatively good deal when they bought annuities – interest rates were higher and longevity expectations lower.

Current lower interest rates and greater longevity mean that their future payments increase in value. By looking at typical annuity rates over the past 12 or so years for a male aged 55 or 70 taking out a level annuity with a five-year guarantee period, one can see the reducing pattern in the last few years which has given pensioners – and regulators and ultimately the government – so much concern.

Conversely, we can deduce or estimate the lump sum that might be payable by providers for £1,000 of annual income. As interest rates have fallen the value of a regular income stream should have increased.What is more difficult to predict is how the market will factor in longevity risks.

Those who might not do so well out of the market will be those whose health has deteriorated since they started their pension. For this group the market will be taking a less generous view of their expected lifespan. However, it may still be attractive for such pensioners to take the cash – if they have other financial support from other pension provision for instance, and they want to make capital expenditure to improve their lifestyle.

So, can we expect to see the emergence of a new market in 2015? Well, as we see it, that will depend on some of the finer details surrounding Mr Webb’s idea. In particular, what will be the tax treatment of the lump sum the pensioner receives in exchange for giving up his or her income stream? Will there be any incentives here – like a proportion tax-free? Then, correspondingly, what will be the treatment for the insurance company which now receives the income – will that be free from tax?

Assuming these important details could be suitably and fairly concluded, then it seems to us that a market could well emerge in time. The specialist annuity providers in particular probably see themselves as very well placed to provide pensioners with information about what might represent a reasonable deal in their eyes.

Possibly the biggest stumbling block of all for this radical idea in the short term, is the sheer scale of change facing the pension industry at the moment. This year proposes to be one of fundamental change for all associated with the annuity industry. From pension freedom and the flexibilities that policyholders will be allowed as they consider retirement through to the guidance and advice that they will receive in the process, everything is new.

Tim Bateman is a partner at accountancy firm Mazars

Key points

Steve Webb has suggested that pensions freedoms should be extended to all pensioners including those who already have a pension in payment.

A lot of legislative and tax changes will have to be made to make the idea a reality.

A second-hand annuities market could well emerge in time.