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Annuities fail flexibility test

My many years of experience in advising individual and corporate clients about annuities and drawdown, advising insurance companies about product development and speaking with the Government and regulators leaves me in no doubt that drawdown will continue to replace annuities as the preferred option for many middle-Britain investors. That is, provided that clients get the correct advice and the industry continues to develop innovative products like variable annuities.

In one sense, annuities and drawdown are opposite sides of the same retirement income coin. On the annuity side, income is guaranteed for life which provides peace of mind and security but this comes at a price. Investors are locked into current gilt yields and there is no flexibility to change the annuity options if circumstances change in the future.

On the other side of the coin is drawdown, where investors give up the annuity guarantee to have more choice, including income flexibility, control of investment and choice of death benefits.

The two charges against annuities were most eloquently articulated by Lord Grantley speaking in a House of Lords debate on pensions in October 1997 when he said: “In my view, there are two overwhelming reasons why people should not invest in annuities under any circumstances. The first is that investing in annuities is contrary to the interests of a family . . . in that they are worth nothing when the investor dies. The second reason is simply that annuities are a lousy form of investment.”

In the past, the relatively unsophisticated nature of the retirement market favoured annuity purchase but as the market becomes more sophisticated, the balance of advantage will tip towards drawdown.

Most clients would agree that their retirement income objectives are to provide a sustainable income in real terms, as long as they or their partner are alive, without taking undue risk but having as much flexibility as possible. How can this objective be achieved? Annuities provide income for life but unless the very expensive inflation-linked option is taken, the income is not sustainable and there is no flexibility. Many people take out level pensions and I do not need to tell you this is far from a no-risk option.

Some people may argue that with-profits annuities can provide sustainable income because they invest in real assets. I agree with this in principle but they are still annuities and fail the flexibility test.

It is misleading to believe that annuities are risk-free, for example, inflation risk and risk of early death. Yes, drawdown is risky but new investment techniques and more sophisticated advice does much to reduce the risk and new-style variable annuities can reduce investment risk significantly. Annuities are inflexible, period.

This analysis shows that drawdown is the only product that can meet the objectives of middle Britain.

If you can invest in a product that provides a guaranteed income for life while offering the flexibility of drawdown but without many of the risks, would you be interested? I am, of course, talking about variable annuity products.

Finally, I get to what I think is the most important reason why providers will wean customers away from annuities – product development. Insurance companies have tried to design innovative annuities but these have not taken the market by storm. Put simply, it has proved impossible to make an annuity look like drawdown but now it seems Billy Burrows, director, William Burrows Annuitiesthat it is possible to make drawdown look like an annuity.

Variable annuities or, as I prefer to call them, guaranteed drawdown products, come in different shapes and sizes but all have the following characteristics – some type of income guarantee, typically that income will not fall below a certain level; a wide range of investments and some of the future investment gain can be locked in, which provides scope for a growing income; the cost of the guarantee is expressed as an additional management charge and the policies are unsecured pensions so investors have the full flexibility of drawdown until age 75. In this way, investors can benefit from an annuity-style income but with the advantages of drawdown.

There is a price to pay to for the lifetime income guarantee and annual management charges differ from company to company but typically range from 0.75 to 1.5 per cent.

It seems that the opponents of variable annuities are not denying the obvious advantages of an annuity/drawdown hybrid – they focus their attention on costs. Everything has a cost and it is down to the adviser and investor to decide if the costs of variable annuities represent value for money.

If you consider all the different forces at work in the retirement income market, you must conclude that over time, more investors will invest in drawdown products. Annuities will still be important but will increasingly find their role limited to those with smaller funds and older investors.

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Questions, questions

Insurers – why do insurers call themselves manufacturers when they don’t make anything? Why do providers keep on adding illnesses covered by their criticalillness policies they know will not result in a claim?

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