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Annuities for the future

Steve Folkard, head of pensions and savings policy at Axa Life, assesses the problems and challenges facing people planning their pensions
and looks at some of the products that might offer solutions

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For the first time in 70 years, we have a coalition Government. Setting aside for a minute the challenges that could pose in setting policy, it made me reflect on the fundamental changes that have taken place over the same period in relation to retirement expectations.

With falling fertility rates and increasing life expectancy, the UK is a very different place for retirees today. There are just four people of working age supporting each retiree in Britain. By 2050, this is expected to reduce to two.
The writing is firmly on the wall for state benefits. A decreasing number of taxpayers will not be able to support an increasing number of increasingly healthy and longer-living retirees.

What are the choices facing the bulk of people, especially the baby boomer generation of the post-war era, who are rapidly approaching retirement today?

Their retirement experience could be a lot different from that of future pensioners unless the market responds to the present environment.
Many retirees from previous generations would have been members of final-salary pension schemes, as are many of the people approaching retirement today. With a promise of a known benefit, now underpinned to a large extent by the security of the protection scheme, little thought needed to be given to what rates might be available for annuities or how the investment markets might cause the value of underlying funds to fluctuate. These pensioners found themselves largely immune from concerns about which choices to make.

But now the choices available will require significant thought as more and more people find themselves faced with a pension fund accrued from a money-purchase or defined-contribution schemes and are faced with choices inv-olving decisions on risk, tim-ing, dependants and inherit-ance tax considerations, to name but a few.

The choices in the retirement marketplace all pose challenges and, even with advice, people can feel as if they are gambling with their future.
Consider the typical options.

First, conventional lifetime annuities. These provide the security of a known, guaranteed payment and no need to make investment choices.
However, the benefits are fixed, including the choice of dependant’s provision, and timing of purchase can have a significant impact on income.
For example, a 65-year-old man retiring in 2000 with a fund of £100,000 could have secured a pension around 20 per cent higher than someone of the same age retiring at the end of the decade.

This means the choice to purchase an annuity can represent a significant risk in itself and is a fairly inflexible choice, although it remains the most easily understood.

Then there is income drawdown. Long established as a more suitable option for those clients with bigger funds, prepared to take investment risk, income drawdown, or unsecured pension as it is officially now known, offers significant flexibility over the conventional annuity choice with the capacity to model the investment portfolio against changing income requirements and avoiding the need to secure specific dependants’ benefits in the event that client circumstances change. However, the significant volatility in the markets seen recently will have made some investors increasingly nervous of the risk of exposing their future income needs to downturns in the market.

Ironically, the issue of investment risk is counter to the risk of fixing income at the wrong time with a conventional annuity. Ideally, clients want to seek ways to limit their downside risk of poor timing or significant market falls while having a potential for upside which makes an active investment choice worth the additional cost.

Finally, investment-linked annuities or flexible annuities. These fix the format of the annuity in a similar way to a conventional annuity but the income generated from the contract fluctuates according to the underlying investment performance.

They provide the advantages of active investment exposure and choice of death benefits with increased flexibility after age 75 and the option to convert to a conventional annuity. The exposure to investment risk remains a major consideration with many options in this market and innovation in this area is seen by many as key to achieving wider take-up of this option.

The role of the adviser is critical in helping clients to navigate the many difficult choices they will have to make as the number of options in the market increases. However, it is my view that in order for the market for advisory solutions to be expanded, product providers will increasingly need to recognise that increasing flexibility on investment choices and income options only deals with some of the concerns of most typical retirees.

What most people would really like is to have the upside potential of active investment without the downside of exposure to future falls in income. If that can be presented in an effective way that clients can understand, then the market for innovative choices is set to expand significantly. This benefit has been at the heart of the variable annuity revolution in many parts of the globe.

With the impact of increasing longevity, market volatility and demand from investors to provide better future-proofing of their investments, variable annuities could become a mainstay in the UK marketplace in the years to come.

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