Open up the annuity choice

13 November 2009 8:00 am

Pension savers in defined-contribution schemes have a greater choice than ever of how to use their fund to provide for their retirement. Yet still only just over a third of savers shop around for the annuity that they must eventually buy and most simply opt for whatever is offered by their insurance company.

With the number of over 65s set to swell by 60 per cent to 15 million people in the next 20 years, this means hundreds of thousands of pension savers are not getting the best deal.

Hargreaves Lansdown head of pensions research Tom McPhail says: “There are 800,000 people retiring each year between now and 2012, all of whom have defined- contribution benefits. Not shopping around will affect their standard of living for the rest of their lives.”

Wealthier pension savers are more likely to be aware of their options because they are more likely to inform themselves or consult an adviser, who can guide them through the retirement maze.

The options range from ordinary annuities to so-called third-way or variable annuities, staged retire- ment, drawdown and alternatively secured pensions.

The continuing low take-up rate for the open market option, which has been available since 1998, has been described by the Pensions Income Choice Association, of which McPhail is acting chairman, as “a national tragedy”.

The association was founded earlier this year to raise awareness of the choice for members of defined- contribution schemes approaching retirement.

B&CE Benefit Schemes deputy chief executive John Jory supports the open market option but believes there is a problem for pension providers such as B&CE, which have built their brand.

He says: “Customers trust us and feel comfortable with us and want to stay with us. There is something odd about telling them to go and buy their annuity product elsewhere. You cannot imagine a Ford dealer telling a loyal customer to visit a Vauxhall garage.

“However, it remains true that, particularly in the sector of the market we cover, a significant number would qualify for an impaired life or enhanced product and would get a better deal elsewhere.”
Annuities do a good job in providing a reliable source of retirement income for life but annuitisation remains unpopular among money- purchase pension savers.
According to a study by consultants Watson Wyatt, nearly 60 per cent of people in the UK say they would not convert their pension savings into an annuity if it were not compulsory to do.

Nearly two in five - 38 per cent- say they want to pass on their retirement savings while 37 per cent say they do not think they would live long enough to benefit fully from their annuity - in other words, they would die before they got the “full value”.

This sentiment ignores the fact that one of the biggest risks a person faces in retirement is living too long and their savings running out.

Guaranteed annuities go some way to addressing the fear of dying “too soon” and those with bigger pension pots have for some years now been able to use drawdown, which additionally allows savers to remain invested and take advantage of potential growth of the fund.
The fund, however, may be exposed to stockmarket falls as well as growth - as many drawdown investors have found out to their cost over the past two years.
One possible solution to this exposure to risk is to take a variable annuity, which offers a balance between the guarantees provided by a traditional annuity and the flexibility and death benefits of a drawdown plan. Sales of these products have now overtaken traditional annuities in the US and are also popular in Japan, although most providers are reporting a contraction of sales since the downturn.

The UK market has also been hit by the economic climate. The biggest seller of variable annuities in both the US and Japan, The Hartford, unexpectedly closed down its UK and Japanese arms and cancelled plans to launch in Germany.

Other insurers, such as Standard Life and Prudential, have delayed entering the variable annuity market in the wake of turbulent market conditions and Aegon was forced to replace its 5 for Life product with the secure lifetime income plan, which simply locks in increases in income levels and protects against falls without a 5 per cent guarantee.

Nevertheless, other players in the market are still active, including MetLife, Lincoln and Living Time, which markets a slightly different guaranteed product backed by Alico.

Whatever the marketers might say, variable annuities do not necessarily solve the problem of balancing income potential with income security.

Rowanmoor Pensions managing director Ian Hammond is a critic of these schemes. “I cannot get excited about variable annuities,” he says. “If you are looking for certainty, take an ordinary annuity. If you are looking for potential growth, then take drawdown or an alternatively secured pension. I do not see the point of something down the middle - particularly when you consider the huge cost of guarantees.”

MetLife, however, believes its policyholders value the guarantees and they have proved their worth. Dominic Grinstead, the firm’s UK managing director, says: “IFAs have clearly been successful in explaining how the guarantees work at a time when the market falls that we have seen over the last two years have illustrated their value.

“Guarantees are firmly established in the mainstream for retirement planning, and advisers have recognised their benefits as part of the range of solutions.”

Temporary annuities are another option that avoids the all-or-nothing commitment of a lifetime annuity.

A temporary annuity can fund a particular phase of retirement, such as prior to downsizing to a smaller home or receiving an inheritance.
Hammond is, however, dismissive of these too, and believes retirees may be exposing themselves to unnecessary risk at the end of the annuity term and that flexibility can be obtained by using an unsecured pension or alternatively secured pension.

It remains a fact that only a small number of clients with bigger pension funds will ultimately be interested in drawdown or variable annuities and the majority of retirees - the 88 per cent whose pension pots are less than £50,000 - will be looking at one of the more traditional annuities.

Pensions Policy Institute research director Chris Curry says: “Greater reliance on defined-contribution pensions in the future will mean that many more individuals will be exposed to the risks of investment performance and will need to convert pension pots into retirement income and engage with the annuity and retirement products market.”

Tom McPhail says the swelling of the impaired life and enhanced annuity market, and the trend towards determining annuity rates by policyholder postcode, indicate an inevitable move towards individual underwriting.

“The mortality cross-subsidy, where the poor with ill health subsidise the pensions of the wealthy, is unwinding,” he says. “Eventually, annuities will be tailored to the life expectancy of each of us.”

Until that day comes, it is essential that potential annuitants get the best deal, whether that is simply by choosing a different provider, choosing an enhanced annuity or simply making sure there is a nod towards index-linking or some other sort of escalation in the retirement package.

Hammond says: “People think they cannot afford an index-linked annuity because, when they look at the graph comparing payments with a level annuity, they do not believe they will live as long as the point where they break even. The actuarial figures are correct and the fact is when they reach that point on the graph they then wish they had built in some escalation.

“However, I guess they think they want more money now while they are young so they can enjoy it.”

This could be a mistake. The PPI’s Chris Curry says: “The amount of income needed by pensioners can increase significantly during retirement, especially as health deteriorates and the need for care increases and yet currently around 90 per cent of annuities purchased are level annuities that do not keep pace with inflation during retirement.

“Individuals will need to manage all of their income and assets, including state pensions, private pensions, savings, and potentially housing wealth, to reach the standard of living that they aspire to.”

 

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