Sticking to the letter of the law

While it is true that if it comes up time and again then it is prima facie evidence of a possible problem; equally it could be a bandwagon effect.

It might be worth looking at how GARs arose. Some pension policies immediately post second world war were in fact endowments with the right to purchase an annuity with the proceeds. My recollection is that they had a minimum annuity rates as a back up.

However, the main growth came in the late 1970s when retirement annuities (the old Section 226) were liberalised by allowing the policyholder to commute a proportion of it for cash.

Most companies changed what used to be a deferred annuity contract into a contract that funded for cash which, after taking the tax-free cash amount, could be used to buy an annuity. There was only one company, Scottish Provident, who rightly said that this was the wrong way round. If the primary focus was the provision of pension then it should remain as a deferred annuity; funding for cash leaves the emerging pension at the mercy of the interest rates prevailing at the time of retirement. SPI was out of line with every other company so, common sense said, they were wrong and eventually it pulled out of the pensions market.

We now know that it was wrong to say that they were wrong. Everyone else was wrong as people with pension plans that have vested in the past 20 years are finding out with the low annuity rates they were faced with. So the majority were wrong. That would have been sad for the policyholders except for one thing. Those companies had listened to the criticism of funding for cash and had put a guaranteed minimum annuity rate, such as £11 per cent at age 65.

Looking back it seems a stupid thing to do, throw in an extremely valuable financial option for nothing. I think there was a concern that if the policy did not provide an annuity but simply funded for cash then it could not be referred to the pension business fund and would therefore be deprived of tax concessions. We now know the fear to be unfounded but at the time it was a real one.

The other point is that the minimum annuity rates were not meant to be financially valuable. The rates were set using a conservative interest rate and mortality assumptions. It was there to prevent a catastrophe for the policyholders but companies did not expect that it would ever be used. What is a conservative interest rate? Remember this was around 1977 to 1988 when the high inflation of the early 1970s was fresh in people’s minds. Some companies thought 5 per cent was conservative others went as low as 4 per cent.

Unfortunately, 30 years on, mortality has got lighter - people are living longer and worse, much worse, inflation has been licked and interest rates started to fall. I remember 20 years ago, when I was the actuary of Royal Life and it looked as if the options would be ‘in the money’ thinking seriously about how to deal with it. We could not purchase an investment that would neutralise it and we reluctantly faced up to the fact that most clients would exercise the option and set money aside for that eventuality. But since then the yields have got steadily worse.

At the end of March this year the 10-year gilt yield stood at 2.9 per cent. Today the 15-year gilt yield is 2.9 per cent and the 20-year gilt yield is 2.8 per cent.

There are three different reasons for the decline in yields. In the early 1990s, inflation started to fall and we had single-digit yields for the first time in 20 years, practically. Then in 1997 Gordon Brown ceded to the Bank of England the control of inflation and short-term interest rates and we started shadowing the Emu. Yields dropped two percentage points and stayed at levels where GARs became valuable, to the client and a millstone for the provider.

Then in 2008/9 following the credit crunch, the government started a policy of printing money - sorry I mean quantitative easing. Normally printing money would cause inflation, too much money chasing too few goods and a rise in interest rates. That may yet happen, but for the moment they are doing that by buying gilts from insurance companies, banks and pension funds. This excess demand for gilts has pushed its price up and yield down so that it has dipped below 3 per cent and sometimes below 2 per cent.

Today the best annuity rate a male aged 65 can get is of the order of £6 for £100 of purchase money – or £6 per cent – so a GAR of £11 per cent would provide nearly double that figure. As the guy in the old cowboy films used to say: “There’s gold in them thar GARs”.

Of course no one had never envisaged that the interest rates would descend to today’s level. If the government’s target for inflation is 2 per cent then one would expect the nominal gilt yield to be of the order of 4 per cent to 5 per cent. GARs would still be in the money but nothing like as much.

So what would I expect life companies to do today? I would expect them to stick to the letter of the contract. If the policy is written to age 70 and the option is shown as being available at age 70, that is all they would get. An annuity on his 70th birthday in the form shown in the policy document. Anything else will not get the same favourable rate. The option will have to be exercised within the window stated. I would expect intermediaries to earn their corn, not bleat.

So far in this century we have piled opprobrium upon banks but it is high time an insurance company and its annuitant customers sued the government for the collateral damage quantitative easing is causing.

Icki Iqbal is a former director of Deloitte

Key points

* The main growth in pension policies came in the late 1970s when retirement annuities were liberalised by allowing the policyholder to commute a proportion of it for cash

* People are living longer and worse - inflation has been licked and interest rates have started to fall

* A GAR can mean someone will double their money