Until relatively recently, people had two options to secure a long-term income stream in retirement.
The first option is the traditional annuity route. You work hard all your life, build up a pension pot and then purchase an annuity on a certain date that will provide you with an income for as long as you live.
The second option was to build up an investment pot – in a bond for instance – and start taking chunks out of it every year as income.
Without getting drawn into the tax implications and the 20-year rule on bonds, there are positives and negatives to each approach.
If you choose the annuity approach, you have the certainty of a defined income for the rest of your life, dependent on the prevailing annuity rates at the time of purchase. However, in purchasing an annuity you forego all control of the money you have built up over your working life. You cannot dip into your fund if you need some cash for a holiday or a child’s wedding or a new car. And if you die, your dependants might not receive a return of fund.
In a bond, you have complete control over your under-lying investment. You can dip into your fund as and when you need to. You can set your own percentage of withdrawal as income. You can switch asset classes according to your changes in attitude to investment risk and if you die there could be a death benefit to pass on to your dependants.
However, you lose all certainty of an income stream for life. You are at the mercy of the performance of the underlying funds. Indeed, you might very well run out of money before you die. At the moment, there is something like a one in three chance of that happening. Your long-term financial security is probably not something that you would be willing to take such a gamble on.
So the options have historically been quite restrictive. Security or control. You choose, you cannot have both. Well actually, you can.
Last September, Aegon was the first provider to bring this concept to the UK market with the 5 for Life retirement solution and since then, several other providers have also seen the huge potential in this market and created their own versions – with more on the way.
Some of these products are pensionable (dubbed third-way pensions), which means that at age 75 you may have to purchase an annuity – depending on the Government Actuary’s Department rates at the time. Others are not pensionable, meaning the customer remains in control of their plan for their whole life.
Surprisingly, although the demand is there, some advisers in the UK have been reluctant to embrace this new thinking and the main stumbling block seems to come down to charges.
Some advisers have dismissed the income for life concept because they believe it is too expensive for the fund choice available. There are others who say they can do the same thing through a well balanced and diversified portfolio.
In reality, it would be very hard for any adviser to provide clients with the same benefits that can be achieved through third-way products.
There is nothing else available on the market that will guarantee to pay customers an income for life (that has the potential to rise), with participation in the markets, a death benefit and control of the underlying fund.
In an initial fact-find, a client is asked what their primary focus is – income or capital? Historically, you were forced to choose between the two, or a bit of both, assuming your requirements were somewhere in the middle.
If you were to choose the middle option (which actually had no one product to meet that need), you were then forced either to give up a bit of control of your money or give up some security around the income stream. What these third-way products do is sit comfortably between these two traditional choices and provide the client with the option to have both control and certainty.
Guarantees do not come for free. There is a cost involved in these types of products. However, they are not attached to the underlying fund choice – or even the increased flexibility they provide. The extra charge is there to provide the guarantee of an income stream for life.
With increasing longevity, there is a threat that people will outlive their assets. We feel that many people would be willing to pay a small amount extra for the security that this guarantee provides.
The fact that many other companies have also identified these changing demographics and are coming to the market with their own products also indicates there is sufficient appetite in the UK for a viable market to flourish.
Third-way products are here to stay. No product is suitable for everyone but, as part of a wider portfolio that addresses customers’ retirement income needs, these products are certainly growing in importance.
Many advisers and big bank distributors have already seen the potential. These products provide customers with a choice they have never had before – control of their fund and certainty of income for sas long as they live.