Significant regulatory change has led to predictions of extreme changes in the purchase of annuities in the UK.
RBC Capital Markets forecast a 90 per cent reduction in the purchase of individual annuities. Learning from the deregulation of financial markets in the 1980s, one needs to be cautious of the risks introduced into the retirement system from individuals having to deal with longevity risk on their own.
In retirement planning, an individual’s ability to customise a portfolio that best suits their needs is important. However, when shifting from lifetime annuities, we should not lose sight of the benefits of longevity insurance.
Annuities that pay a fixed income for life provide a unique longevity hedge that is not available from non-insurance products.
Much like flood or fire insurance, lifetime annuities share risk over a large pool of people, allowing individuals to hedge the risk of outliving one’s savings. Without a large starting amount, it is difficult to self-insure with capital markets alone.
This is where guaranteed income in the form of annuities from well-capitalised and prudentially regulated entities provides benefits.
Choice is a good thing, as each person has unique needs and preferences. However, in a well-balanced retirement portfolio, lifetime annuities should still play a role. The need for an effective private-sector retirement solution is high, especially for governments seeking to reduce expenditure. Getting it right will dictate how regulated the industry is likely to be in the future.
Australia is grappling with the retirement income question, in spite of having a successful accumulation system. The common characterisation of its system, as not having an issue with lump sum withdrawal, is misleading.
Lump sum withdrawal is an issue; it is just not a significant one at present. As more people move through the system and the average balance gets larger, the risk of excessive lump sum consumption rises. Retirees’ ability to fund lifetime income is important for the success of the system, and government policy is likely to become more focused on this phase.
And this is where the UK is starting, from a healthier position of income-orientated retirement consumption. People here are used to drawing an income rather than spending a lump sum.
Maintaining this focus on producing a retirement income should not be lost to the total return maximisation objective used during accumulation. The combination of guaranteed products and traditional assets into a long-term portfolio allows individuals to balance the need for lifetime inflation-protected income and the ability to access one’s savings.
Moving away from compulsory annuitisation should provide individuals with an improved opportunity set to plan for their future. The flexibility to take advantage of traditional assets and avoid locking all of one’s savings into very low interest rates on lifetime income streams is a big positive. It is just important that it does not lead to a complete movement away from annuities.
Annuities have a key role to play for many retirees. Let’s hope deregulation does not mean throwing out the baby with the bathwater.
Daniel Needham is chief investment officer at Morningstar Investment Management
