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Kim Lerche-Thomsen: Time to face the truth on annuities

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When I reflect on the current state of the retirement income industry, I can’t help but be reminded of the film The Matrix, in which the hero, Neo, is offered the choice of the red pill that opens his eyes to the facts of his environment, or the blue pill where he can continue to live in ignorance.

Sadly, retirees today continue to be served the blue pill, and the current ABI initiative falls far short of changing this as it continues to steer young, healthy retirees towards a lifetime annuity without a meaningful reference to the alternatives.

I suppose we shouldn’t be surprised that the lifetime annuity remains the mainstay of the retirement income market in the UK. It is after all the only product that guarantees an income for the rest of the retiree’s life.

In the era of final salary schemes, a lifetime annuity provided the continuation of a salary-related benefit into retirement, and delivered a promise made to the employee while they were still working.

It also acted as an insurance product, as benefits would continue to be paid no matter how long you lived, even although that was unlikely to be for long.

Fast forward to 2014, and the world has changed (think how far telecommunications have come in that time). Annuity rates have plummeted, and yet here we are, still leaning on the lifetime annuity to support our ever-increasing, longer-living, retired population.

Indeed, over 90 per cent of retirees buy a lifetime annuity, presumably on the premise of its lifetime guarantees, but without really understanding what it is they are trading in order to get those guarantees.

In this day and age, people should be given the opportunity to test-drive their retirement before locking themselves into a product that has to serve their financial needs for 20 years or more. People talk about inertia, but I think people panic. They need an income, they want their tax-free cash, retirement is upon them and they have to make a decision. How cruel to make this decision an irreversible, life-long and, more often than not, uninformed decision.

For healthy people, locking into a guaranteed income at retirement will almost certainly mean a poorer deal. That’s not to say that a lifetime annuity might not become the ideal product for them later in life, but they would be far better keeping their options open and delaying this lock-in until ill health, old age, or indeed, higher interest rates set in.

In the wake of low annuity rates, they also find themselves trading a bit more income for a single-life annuity, in denial (or ignorance) of what that might mean for their spouse if they were to die.

If there is one thing the Government can, and should do, it is to allow people to retire with an income, and some breathing space to figure out what their long-term options are. This is what fixed-term annuities do.

“All I am offering” says Morpheus to Neo as he hands him the choice of pills “is the truth – nothing more”. Don’t retirees deserve the same?

Kim Lerche-Thomsen is chief executive at Primetime Retirement

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Comments

There are 11 comments at the moment, we would love to hear your opinion too.

  1. Fixed term annuities are really nothing more than drawdown by another name though. Clearly drawdown can be entirely appropriate for some people. The double-edged sword that is self-evident is that of attempting to guess what the future holds… better investment returns? higher inflation? higher annuity rates? worsening health? blah blah… I like the Matrix analogy, though frankly whether its an annuity or drawdown is really not the “wool [world] being pulled over our eyes” but the reality wake up is that unless you have saved a load of money, your retirement looks bleak and our human battery life keeps being extended… (or at least so we believe)… so its time to ask yourself, what do you believe? and indeed if pensions are even the “best” way to save for “retirement” whatever that means to each person.

    The reality is that this is complex because it is individual and therefore requires a thoughtful discussion with the client, perhaps several discussions. In practice this isn’t possible for everyone and so we need far better “off the peg” solutions. I’m not sure that giving most of the population another chance to delay making a decision about their pension is likely to be worthwhile, educating them about it is worthwhile!….Australians bit the compulsory pensions bullet in 1992… we are still slowly making progress towards AE, but with opt outs all over the place. If Steve Webb (or any political party) was serious about this, surely they would scrap NI and replace it with a non-opt out pension with a Government backed minimum and stop all this daft restrictive stuff about annual and lifetime allowances… just restrict the tax relief and have done with it.

  2. Not surprising that this viewpoint comes from a product provider with a vested interest. A great pity we can’t have an unbiased opinion, with relevant numbers to prove the point.

    As I mentioned in another post (after attending a seminar which covered the topic). Without making dramatic assumptions about future rates or health, just crunch the numbers and tell me if they make sense? Ask what are the margins on an ordinary annuity compared with one of these other types and I think the motivation will become clear.

    From figures I have seen it would certainly appear that in most normal circumstances an annuitant would lose out by taking a fixed term options and this doesn’t account for the opportunity cost of the steady income provided by the conventional annuity. From what I have seen income when compared to the equivalent conventional annuity reduces by about 8% after 6 years.

    The logic is also flawed. If the client has a small pot he is not really suited to these alternatives. For clients with large pots (say over £200k) the assumption is that the pension is their only retirement asset. I would say that most of these people have other investments besides with which to take market risk and have an underpin of a certain income (albeit hostage to inflation) provided by a conventional annuity which can be written in joint life from the outset.

    Then of course many are now taking the route of continuing to work (perhaps part time) well past age 65. Some enter crystallisation by taking tax free cash and; leaving the residue invested – a far cheaper option than a temporary annuity.

    I have a feeling in my water that these products will eventually end up like pension transfers and we will have a review and compensation in 5 to 10 years’ time. Never forget that it was in the main the product providers who were cajoling advisers to consider transfers. So it would seem that nothing changes.

    Just think where the main advantage lies – with the provider, the adviser or the client. I think that it looks as if the client is in third place.

  3. Fixed term annuities with the balance of the fund remaining invested are all very well but risky.

    1. The invested fund may not perform as hoped.

    2. Annuity rates may continue to decline.

    3. The government has forced such schemes to conform to the Income DrawDown rule of a complete re-jig every three years, and a three year investment period is too short to take a chance with any asset class other than gilts and investment grade bonds which are likely to suffer a severe hit if and when interest rates rise. What was wrong with a five or six year investment period? Canada Life’s Annuity Growth Account was a great product but is now a very much more risky proposition.

    That aside, one has to ask why so many people are still talking about anything other than an alternative to the core problem, namely the annuity rates trap? A Retirement Income Bond geared to utilise the entire fund over the remaining underwritten lifetime of the retiree, with an insurance element against early fund burn-out, would sweep away all these problems at a stroke without compromising security. The level of income could be recalculated periodically to reflect changes in health, death of one party or better than anticipated investment returns. Also, any unspent funds on death of both retirees could (and should) be allowed to pass down tax-free into PP funds for the next generation. What’s not to like? Why is Steve Webb talking about everything and anything else?

  4. I agree with all the previous commentators but especially Dominic. There is no ‘golden’ product that is right for all because everyones situation is different.

    The way i see it is that at present there are only two options when accessing pension funds, drawdown or an annuity. Everything else is a variation on those basic rules. What we really need is something new, another option, not the constant tweaking of existing rules. Basically something like what Julian is suggesting.

    Having said that no product no matter how innovative is going to solve the problem of not having saved enough for retirement. That is why, fundamentally, i believe the government is doing the right thing with AE. Is AE in it’s current format the right thing? I would guess not but the theory is sound, in my opinion.

    Over the next 5 to 20 years the % of time spent by advisers advising on retirement solutions is only going to increase (i predict it will be upwards of 75% of our time) and the solutions offered will become more varied. Even now the best options are sometimes a combination of annuities, drawdown and even continuing to work 1 or 2 days a week. I’m 32, by the time i reach retirement age i think i’ll be looking forward to joining all my friends at B&Q 2 days a week and use a variety of income methods (drawdown & annuities) to top up the rest of my pension income.

    All the above is obviously my humble opinion.

  5. Julian said – “Also, any unspent funds on death of both retirees could (and should) be allowed to pass down tax-free into PP funds for the next generation.”

    Couldn’t agree more. In return for pasing tax free – as long as the funds remain locked in a pension environment thats within current lifetime allowance limits, what on earth is wrong with helping the next generation to build up their pension funds. I thought that was one of HMG’s major aims. Seems to kock several problems on the head.

    Oh, except I suppose that HMG would lose tax revenues…………….and we can’t have that……can we?!

  6. To pick up on some of the comments made.

    It is clear that there is still quite some confusion in the market as to how Fixed Term Annuities work and the benefits they offer. For example, Julian says:

    “Fixed term annuities with the balance of the fund remaining invested are all very well but risky.

    1. The invested fund may not perform as hoped.”

    This is not true. With a Fixed Term Annuity your remaining fund is not ‘invested’ in the sense of a traditional Drawdown product. What you get back is a fixed, known maturity lump sum at a given point in the future. This gives the client a huge amount of security in that they know not only when but exactly what they will get back (unlike conventional Drawdown).

    We would also, respectfully, disagree with Harry in his assertion that a Fixed Term Annuity will only return a better financial outcome if one makes “dramatic assumptions” about future rates and health. In fact, the gap between ‘best in market’ annuity rates and ‘default’ fixed term annuity rates have been narrowing for quite some time. They are at a point now where even a relatively modest rise in interest rates (roughly 0.5% for someone currently aged 65) would give a future annuity rate equivalent to or greater than they are at present. Add to that the possibility of a future uplift due to health deterioration – even small uplifts for ‘minor’ conditions like Diabetes and Hypertension (say 10% or so, what Enhanced Annuity providers would regard as a fairly modest uplift) will often deliver a better financial outcome)

    The main point, though, is that Fixed Term Annuities – like other options (investment linked, enhanced, drawdown etc) should at least be ruled out – in other words clients should be aware of their options, even if they then decide that (say) a Fixed Term Annuity is not for them. A Lifetime Annuity is not ‘risk free’ (just like all financial products) and retirees need to be made aware of the consequences of making a lifetime decision, especially if they are relatively young (under 70) and in good/reasonable health.

    The great thing is that these alternatives are at least now being debated in forums like these!

    Stuart Wilson
    Marketing Director
    Primetime Retirement

  7. @Stuart Wilson
    Fiddlesticks. What you get back might well be ‘guaranteed’; It is guaranteed to be a lot less than you started with and from all the figures I have seen you would be hard pressed to end up with as much income as the initial annuity – unless of course you were practically terminally ill.
    Sure I look at these as a duty of care and always crunch the numbers. They always look a very poor deal, unless I am prepared to make outrageous assumptions concerning annuity rates or health – which I am not.
    Mr Wilson may disagree with me all he likes, but on each occasion that I have compared these, the client is worse off. I just take the client’s age and add the number of years to the expiry of the guarantee and then see what the Annuity rate would be. I am not in the business of guessing that interest rates will go up or that my client’s health will deteriorate substantially. Why, I could even in that case make assumptions about tax rates, inflation, the possibility of a Lottery win and goodness knows what else. We have to deal with what we know – not what we think might happen – therein lies disaster. By all means we can mention the various scenarios, but are you seriously suggesting we should rely on them? Sure a conventional annuity is subject to inflation – we point that out, but if the initial income is surplus then there is no law saying you have to spend it all. Anyway as I have said there is an inescapable logic. Those with large funds invariably have other assets. Those with small funds are not really suited to gambling.
    The terminology used is at best very misleading for uninitiated clients. I take particular issue with the word ‘Guarantee’. Even I take it to mean that I would be guaranteed to get back what I put in. I do hope that the Regulator takes a very close look at these products.

  8. @Harry Katz

    You might be interested to have a look at the ‘Fact and Fiction’ report produced by LV which considered the scenarios where a Fixed Term Annuity might produce a better financial outcome than a Lifetime Annuity. They also produced an excellent online calculator to help IFAs demonstrate this to clients, it is well worth a look because it is not skewed towards providing a favourable return to FTAs. It gives a genuine comparison based on whatever assumptions you care to make – high or low.

    Again, I would dispute the fact that you need to make outrageous assumptions in order to make a positive call on an FTA, but that is rather getting off the point. Surely the point is that clients are presented with options? A client may well take the view that they would rather ‘wait and see’ what happens in 5 or 6 years time before committing to a lifetime annuity? They might well take the view that they would rather keep control of their pension fund than, potentially, see it disappear back to the insurance company after their death? Especially if they can do this without exposing their remaining fund to ongoing investment risk? They might well take the view that a degree of ‘wriggle room’ and flexibility is worth having for the sake of what is increasingly only a marginal difference in income rate between an FTA and a ‘best in market’ LTA?

    Just like a Lifetime Annuity, a Fixed Term Annuity is not going to be for everyone. But it is increasingly becoming a consistent feature in the recommendations of more and more advisers.

  9. Also Harry, I think you misunderstand how Fixed Term Annuities work. Your reference to the use of the word ‘Guaranteed’ for example.

    It is the maturity value that is guaranteed (Fixed Term Annuities typically refer to ‘Guaranteed Maturity Amount’ or ‘Guaranteed Maturity Value’). These maturity lump sums ARE guaranteed. They are fixed and known at outset and unaffected by investment performance.

    I don’t think the term ‘Guaranteed Maturity Value’ used to describe a maturity value that is guaranteed is at all misleading.

  10. @Stuart Wilson

    I don’t misunderstand at all. As far as these are concerned I recently attended a retirement seminar, part of which included a lengthy presentation by one of the major product providers of these types of products. I actually have the slides. It is perfectly plain from these and from the presentation – once the presenter was questioned – that these products (at best) struggle to provide equivalent returns at maturity to what would have been obtainable at outset from a conventional annuity.

    As to your defence of the term Guaranteed. I’m afraid this is just semantics. I give you £160,000 and you guarantee to return £105,079 after 10 years (actual figures from the presentation). That’s a 34.33% drop. Some guarantee – a guarantee to lose money! For a 65 year old the £160,000 would buy a level annuity (non-smoker no health issues) of around £9,537 at current rates. (6%). In ten years at current rates the annuity on the guaranteed amount would be £8,369 (7.96%). But this is some 12.2% less than the starting annuity. So his health and/or annuity rates would have to make up this shortfall. Would you want your client to bet on that?

  11. @harry katz

    Without seeing the slides it’s hard to comment, but when you talk about a return of £105,079, is that just the maturity value? What about all the income the client has received over that 10 year period? I don’t think it’s fair to say that’s a 34.33% drop when the client has been taking an income for 10 years! Assuming the FTA paid a similar rate of income (let’s say £9500 pa) then the total return over 10 years would be £200,000 but as I say without seeing the basis for that figure it’s hard to say for sure.

    The same client opting for a Lifetime Annuity would have to live for 17 years just to get their money back (average 65 year old male will live about 18 years). Is that a good return?

    Rates of course differ from provider to provider, but in the case of Primetime Retirement our product offers rates of income equivalent to ‘best in market’ lifetime annuity rates so it is possible for a client to achieve an income equivalent to a LTA today. Of course future rates (and health, and personal circumstances, and legislation, and inflation etc etc etc ) cannot be predicted. So of course there is risk in choosing a FTA. But there is also risk in choosing one shape of income for the rest of your life that you can never amend. As long as the client is aware of that and has considered their options (not just FTAs) then great.

    Anyway, they are all Points of View and Fixed Term Annuities (like Lifetime Annuities) have their supporters and detractors. It has been interesting debating this with you. We’ll have to agree to disagree but there’s no shame in that (:

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