Personal PensionMar 21 2012

Annuities: From static to flexible in 50 years

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When the first issues of Money Management were hitting the shelves 50 years ago, so was the first raft of annuity products. Following new legislation in 1956, what we now call a lifetime annuity emerged. And this is the way it stayed for the next 30 odd years – with just one option for retirees.

There was very little progress in this period as the impact of changing demographics of the UK had not yet been seen. The longevity issues that plague the front pages and providers’ ingenuity now were a dot in the distance.

However, the first real innovation came in the mid 90s when the market and legislation woke up to the issues facing the retirement market. 1995 saw the advent of drawdown, giving more flexibility and, for the first time, giving retirees an option beyond locking into one income for their retirement.

Where the first 30 years of annuities were slow on innovation, now came a raft, with flexible annuities coming around the millennium, followed by unit linked guarantee products and then fixed term annuities. Not only have the options at retirement evolved, so too has the customer base for these products.

These days there is not one homogenous group of retirees. The times of everyone reaching age 65, retiring and buying a lifetime annuity are gone. In a world where pensioners now work part time, travel the world or continue in their jobs full time, more flexibility is needed. Because of this the annuity market has had to adapt to fit these groups.

They can broadly be split into four groups. The first are those that want a guaranteed income, who see this income as the be all and end all. They will retire fully and want the maximum income that they can get for their retirement, much as the retirement market used to be. It is likely that they will end up buying a lifetime annuity, although within this group there will be a split of those that get a standard annuity and those that get impaired or enhanced products, due to ill health.

The next group is those that want some underpin on their income – some guarantee on the income that they will receive – but still want the potential for it to grow. Here is where with profit annuities or unit linked guarantee products come into play.

Then there are those who are sitting on the fence with their retirement circumstances. Some may have a DB scheme or may want phased retirement or part time work and so want to take a partial pension. Here the fixed term annuity comes into play, offering a halfway house, with a steady income for a set period, but allowing flexibility when the term ends.

Lastly is the group that are willing to take on more risk and so opt for drawdown, be it capped or flexible. This obviously gives the chance to be more adventurous with investments, although capped drawdown now has limitations, following the reduction to 100% of an equivalent annuity rate, down from 120%. This group will likely have a DB scheme that will provide the maximum income requirement of £20,000 for flexible drawdown and, to a certain degree, will see this additional pension pot as bonus income – meaning that they are willing to take more risk with it.

Obviously a key issue for all of these sets is that annuity rates are at an all time low at the moment, with many questioning why they would want to tie into a lifetime annuity at these low rates. This means that more may be considering an alternative option at the moment. However, the trend for annuity rates has been to consistently fall, meaning that those opting for a fixed term are, to a large degree, assuming that they will have ill health in the future when an enhanced or impaired annuity becomes an option.

So what does the future look like for annuities? One thing is for sure, we are not going to see another period of 30 years where no change and no innovation occurs. The biggest challenge now is tackling what can be referred to as U Gen, the uncertain generation.

MetLife’s product marketing director Peter Carter says, “It is the first generation of people who are turning 50 now who are having to rely almost solely on their DC pension pots where previous generations have had all DB or combinations of DC and DB. And how do they do that? This is why we need more flexible products that fit in with people’s circumstances.”

With this December seeing the introduction of the Test Achats case on gender ruling that went through the European court, which means that annuity prices cannot be based on gender, it seems inevitable that the industry will move away from its model of standard rates for different genders. In the same way that the term assurance market evolved in the 70s, with the addition of smoker and non smoker, so too will annuities.

“What we are going towards is an annuity market that will become fully underwritten,” says Carter, adding, “The annuity market will become far more segmented; the idea of a standard annuity rate is going to disappear. It will just be dependent on particular circumstances. That will be a key driver for the future.”

Another challenge to address is the issue of longevity and people essentially being out of the workplace for longer than they are employed, in both their early years and in retirement. This presents challenges that the market must meet, in providing an income for retirement while also being mindful of the fact that retirement may well last for 30 or more years, so long term investment growth is needed.

Carter adds, “Now the challenge for providers is how you give people access to some of that additional performance while also protecting them on the downside.”

Education will be another of the key hurdles in the market. While it has come a long way from 50 years ago, when people defaulted into a lifetime annuity, much of the time not fully understanding the implications, more progress can be made.

It was only in 1988 that the open market option (OMO) became compulsory on personal pensions and until then providers could dictate that an annuity must be bought with them.

As Carter explains, “I think that people with large pension funds have tended to shop around anyway. The real challenge has been that as more and more people got DC pension pots and smaller funds, they have not considered the implications when they came to choose their income.”

While the OMO and the ABI’s new code of conduct for insurance providers, putting more onus on them to provide information to consumers, may not lead to everyone shopping around, the key thing is that those people that do stay with their original providers will do an active decision, rather than because they could not be bothered doing anything else.

The more that people get involved in the retirement process the more they will call for services from the market. Technology could well play a key role in this and the obvious comparison is with the car insurance market, which has largely moved online. It could be that in the future, in addition to having annuity comparison services, we also have entire online annuity purchase systems, with customers entering details themselves and fully understanding the products on offer.

“Technology is the stepping off point for new solutions to arise,” Carter says, adding,” I think on the one hand it will reduce the cost of transacting this business, which means people can get advice on smaller pots than they are otherwise able to, and on the other hand it will enable people to self service if they wish.”

The large issue in the pensions market is the constantly changing regulation and that appears unlikely to stop in the coming years. From the introduction of the OMO in the 80s, the advent of income drawdown in the 90s and then the raft of changes at A Day, the market has certainly been kept on its toes in recent history.

“I think that there is probably still some way to go in terms of flexibility that legislation can allow. We think that longevity insurance should be allowed in income drawdown. We’ve also spoken about using income drawdown for payment of long term care, even for those in capped drawdown. So I think there is a long way to go.”

But changing legislation is not always a good thing – making many believe that pensions are constantly changing and so not a reliable vehicle for saving. Be it the rate of tax relief on offer or the limits on investment into a pension, change creates uncertainty, which has not helped the sector.

In the coming years the Government needs to ensure that it engenders an attractive environment for pension saving, to balance the raft of people now saving into their ISAs, rather than their pension. One option, Carter says, is a mini pension, which would bridge the gap between the traditional personal pension and the ISA, with tax relief available but people having controlled access to the funds.

“The idea is that people get tax relief on the way in and they could take money out as they went along but it would be that they had still made a positive contribution to their pension savings.”

The key message thought is getting people engaged with pension saving at an earlier stage. Because some things are for sure, people are living longer, the options are increasing and the State will not always be there to pay.