View more on these topics

A bridge too far?

One of the common objections levelled against guaranteed retirement income products is that they are overpriced. But overpriced compared with what? Annuities? Or simply over-priced for what they offer?

Guaranteed income products are the new third-way alternatives that bridge the gap between full income drawdown and annuities. They give some guaranteed income but not quite at the same level as an annuity. They also provide some of the features of drawdown, such as better death benefits and the ability to stay invested in assets that should deliver superior long-term returns.

Another way to approach the debate is to ask whether annuities “under-yield”.

The return on an annuity comprises two elements – the asset return and the mortality gain. For the purpose of this debate, the mortality gain is present both in annuities and guaranteed income products, so we can disregard it.

The assets backing annuities range from risk-free gilts to investment-grade corporate bonds. At the time of writing, the yield on long-dated gilts is 4.8 per cent and on A-rated corporate bonds it is 6.4 per cent. For the sake of being fair to annuities, let us assume that the provider holds assets towards the corporate bond end of the scale and the portfolio yields 6 per cent overall.

Now to guaranteed income products. What is the likely return from these? If the client remains 100 per cent invested in equities over the long term, they can expect a return equal to the risk-free return plus the equity risk premium. The equity risk premium is the extra return expected by investors for placing their capital at risk.

Numerous historical studies place the UK equity risk premium in the range of 5 to 6 per cent. Let us be fair to annuities again and assume it is at the lower end. That means that the expected return from equities might be 9.8 per cent (the risk-free rate of 4.8 per cent plus 5 per cent equity risk premium).

So far, so good. We expect guaranteed income products to yield 9.8 per cent and annuities to yield 6 per cent.

Now to charges. Annuities do not show their costs but that does not mean they do not exist. There are admin expenses for set-up and maintenance, sales costs such as initial commission, asset management expenses, not forgetting the provider’s profit margin. This will come to between 1 and 2 per cent, expressed as a reduction in yield. The upper end assumes a higher profit margin and expenses.

Let us assume that the annualised cost, as a percentage of assets backing the annuity, is 1.5 per cent. That means that the true net of expenses return to the investor is 4.5 per cent (6 per cent minus 1.5 per cent).

Now to guaranteed products. Their charges fall into three camps – fund management expenses, the guarantee charge and sales/advice expense.

The fund management charge is typically 0.5 to 1 per cent. Let us split the difference and say 0.75 per cent. The guarantee charge for an equity portfolio might fall in the range of 1.5 to 2 per cent. Let us assume it is 1.75 per cent. Finally, initial advice typically costs 3 per cent of the fund and ongoing advice typically costs 0.5 per cent of the fund each year thereafter. Expressed on an annualised basis over 10 years, the advice cost is around 0.9 per cent.

So, the total cost of a guaranteed income product invested 100 per cent in equities is 3.4 per cent. That gives a true net of expenses return of 6.4 per cent (9.8 per cent minus 3.4 per cent). This is nearly 2 per cent a year better than the annuity.

If the argument is that the guarantee is over-priced relative to what it offers, the answer is simple. Don’t buy it. Take full drawdown and bear the investment and mortality risk yourself.

John Lawson is head of pensions policy at Standard Life


Domestic affairs

The Adviser Fund Index questionnaire for April shows that the panellists believe the UK is going to do relatively better than the US and Japan over the next 12 months.

Only here for the beer

Cambridge University folklore tells of a student who, trawling through ancient legislation, found he could sit his exam while supping a beer. When he turned up to the exam and produced the proof, the astonished adjudicator brought him a pint. The next day, he was summoned to the don’s office and fined for sitting an exam without wearing his sword.


News and expert analysis straight to your inbox

Sign up


    Leave a comment


    Why register with Money Marketing ?

    Providing trusted insight for professional advisers.  Since 1985 Money Marketing has helped promote and analyse the financial adviser community in the UK and continues to be the trusted industry brand for independent insight and advice.

    News & analysis delivered directly to your inbox
    Register today to receive our range of news alerts including daily and weekly briefings

    Money Marketing Events
    Be the first to hear about our industry leading conferences, awards, roundtables and more.

    Research and insight
    Take part in and see the results of Money Marketing's flagship investigations into industry trends.

    Have your say
    Only registered users can post comments. As the voice of the adviser community, our content generates robust debate. Sign up today and make your voice heard.

    Register now

    Having problems?

    Contact us on +44 (0)20 7292 3712

    Lines are open Monday to Friday 9:00am -5.00pm