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Lucian Camp: The toxic elements that led to the downfall of annuities

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Judging by the recent Budget, it looks as if the third of the three biggest and best ideas that the financial services industry has ever had for looking after the long-term savings of ordinary people has been dealt a massively damaging blow. Just like both the others.

To recap, each of these three big ideas dealt with an important area of risk potentially devastating to the financial wellbeing of people with limited resources. 

The first was the managed fund. That dealt with concentration risk, which small investors typically face as a result of insufficient diversification across securities, markets and asset classes.

The second was with-profits investing. That aimed to take care of timing risk – the risk that long-term savers would be committed to a timetable that might fall horribly out of line with market movements and so find themselves obliged to cash out at inappropriate moments.

And the third was the annuity. That was all about longevity risk – the risk that people living longer than expected in retirement would outlast their savings and face dire poverty in their later years.

Happy consumers

In principle, when explained, all three of these risk-management ideas were and still are popular with consumers and do much to alleviate some of their biggest concerns about long-term saving. 

In principle again, consumers are right to feel their concerns so alleviated. Concentration, timing and longevity risks are three of the most dangerous downsides to the whole idea of long-term investment and providing some protection against them is surely the very essence of what insurance companies exist to do.

In all three areas it was not that the consumer needs disappeared. On the contrary, in a world of increasingly volatile markets and ever-lengthening life expectancy, those needs have become greater than ever.

What went wrong was that the financial services industry so perverted and distorted all three of these big ideas that in the end they all became almost untenable.

As I understand it, the perverting and distorting took slightly different forms in each case.

For managed funds, it was mainly a combination of extortionate overcharging and lazy and incompetent fund management, with a heavy dose of opacity to make sure no one realised what was happening.

In the case of with-profits, opacity played a major role here too. But the chief factor was a serious shortage of actuarial integrity, with actuaries signing up to promises they should never have made and giving in to management pressures they should always have resisted.

And now in the case of annuities, it is different again – a toxic combination of product providers and distributors conspiring to create a dysfunctional market providing unacceptably poor outcomes for the majority of consumers. This has
been exacerbated by a bunch of other factors, including over-cautious regulation and the unintended knock-on consequences of quantitative easing.

Deserving of punishment

What is particularly tragic is that over the years, the industry managed to tarnish all three of these big and important ideas to such an extent that within the sector at least, the hammer blows dealt to all of them have been widely welcomed.

At last, industry experts and commentators have said, these terrible rip-offs are being brought to, or at least towards, a much-deserved end. The fact that in their absence many consumers would inevitably be exposed to hugely dangerous levels of risk has been largely ignored.

Speaking as someone whose pension pot suffered the effects of the biggest stockmarket fall of recent times on his selected retirement date, the timing risk looms largest for me.

If I had, in fact, intended to retire on that date, my pension pot would have been worth about 8 per cent less than if I had been born one day earlier, and indeed 15 per cent less than if I had been born a month earlier. And if that is not the kind of risk which, if understood, would put people off the whole idea of long-term saving, I do not know what is.

But that is old news. The Chancellor’s proud proclamation that “no one will ever need to buy an annuity again” is the current news.

Life’s greatest uncertainty 

In principle, annuities are the best way of dealing with what may be life’s greatest uncertainty. We do not know, and in most cases will never know, how long we are going to last.

Without annuities, we are likely to face a pair of counterbalancing risks. On one hand, the most obvious risk is of outlasting our savings and being reduced to dreadful poverty. But on the other hand, the risk is of living a life of great privation and self-denial, only to drop dead in short order and realise as our final thought that we could have been happily tooling around in a Steve Webb-style Lamborghini for our last few years.

Having spent my career in marketing, I am not in a position to defend any of the technical criticisms of the three big ideas.

It has been said that while each product did indeed respond to a genuine and important need, the way that they do so is now simply out of date. 

Managed funds, with-profits investment and annuities are all steam-age solutions. At one time, all of them – just like steam locomotives – represented the best we could come up with. But these days, continues this argument, we have far better technology and these old boilers are ready for the scrapyard.

I am not clever enough to judge the truth of that. But in all three cases, it is not true to say that the old idea was dispensed with when a newer and better one became available.

On the contrary, in each case, the only alternative on offer at the time has been to throw the risk back onto the shoulders of consumers, leaving them (and their adviser, if they have one) to grapple as best they can with the dangers of concentration, timing and longevity risk.

These are so obviously unsatisfactory and unreasonable demands to make of individual investors that common sense says the stories could not end there.

A generation after the discrediting of managed funds, a new crop of multi-asset portfolios is looking much like the same idea under a different brand name. 

Absolute return funds and other volatility-managing concepts are said to parallel the upsides – but not the downsides – of with-profits.

And I suspect that in 10, 15 or 20 years’ time, a new approach will be found to manage longevity risk. I have no idea what it will be but I am certain that the word “annuity” will not appear anywhere in its name.

Unchanging consumer needs

Once we all get over the excitement of getting rid of the discredited old concept, we gradually realise that the consumer need it responded to has not gone away and indeed is just as big and important as it ever was. 

We then have to think of a new solution – with the essential requirement that it must not look or sound too similar to the old one.

These next-generation solutions may or may not eventually deliver better outcomes. But even if they do, I still think that is an entirely inadequate justification for a modus operandi in which the industry comes up with big ideas to meet big consumer needs and then, through a combination of its own greed, incompetence and evasiveness, manages to hollow them out so badly that eventually they become almost entirely discredited in the eyes of the people who created them. We really cannot go on like this. If we do, it is certain that before too long our next generation of big important ideas would start going through the same depressing and damaging cycle.

Lucian Camp is founder of Lucian Camp Consulting

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Comments

There are 10 comments at the moment, we would love to hear your opinion too.

  1. One of the most sensible comments i have read in a long time.

  2. goodness gracious 14th April 2014 at 12:24 pm

    Lucian, absolutely correct in your analysis. Nothing wrong in Managed funds in their concept, but they were also used by some to prop up failing internal funds and had lazy management. I cannot see much greater attraction in multi asset, risk managed new super improved one stop shops either. I am still suspicious about their charges once totalled up and, judging by the amount spent in their promotion, must be thought to be highly profitable by their promoters.
    With profit funds were really a solution to the age old problem of unsophisticated investors wanting statements that show percentage increases taking income and growth as one. However, when these became unitised, the writing was on the wall and those remaining in this type of fund, with a few exceptions, have been poorly dealt with.
    There is obviously something wrong with an annuity market that pays more for voluntary purchase than compulsory purchase, citing commercial competition. The hurdles some insurers put up to attempt to keep an annuity within their group is staggering! Although the letter of the law is respected for paperwork sent at retirement, the open market option seems to be hinted at as being difficult/costly and not particularly beneficial. To send open market option transfer paperwork is always a low priority, why do they need it, a signed letter should be enough. Now I note non matching signatures seem to be a further excuse, as if someone’s signature remains totally the same over 25 years. After all, when requested by an IFA, we do the ID & V. Do they employ handwriting experts, I suspect not but just want to place more pressure on the client so they give up.
    So the chancellor’s relaxation of rules, the FCA investigation of legacy products has hurt the insurers share price, perhaps this will be a wake up call to those insurers who look after their own agenda rather than putting the client and adviser first. The trust placed in a load of these firms has not been reciprocated and if their business model is shown not to live up to the highest standards, let them fail.
    Whatever products are launched over the next few years to deal with basic needs of the population, will they really be transparent?

  3. From experience, the biggest fear clients have is insufficient (or uncertainty to their) income in retirement and for this reason, providing the annuity market retains in existance, there will be clients who will suit a ‘guaranteed’ lifetime annuity.

    Whether it’s the most effective method of income generation compared to (for example) investment backed annuities or drawdown is a moot point given that – as Lucian explains above – there is transferrance of risk.

    Post budget, the recent annuities we arranged have been ‘re-reviewed’ and the annuity option remains the favored option; for those who are ‘at retirement’ we still see clients placing a value on security of income despite the improved flexiblity they now have.

  4. …or to paraphrase a renowned key figure who was once top dog at Commercial Union Life: ” Mourn not the annuity, for it is not dead”
    Anyone remember him?

  5. As erudite, precise and just right as ever, lucian

    Just a thought from me on longevity risk (which of course is about to get much more expensive because of perceived or actual selection)

    The customer problem always was that early death resulted in “them” getting all the money. Say a not for profit social group where each member chose to earmark certain assets within a risk pool (and from which they withdrew (say) 5% a year as an income). On death those assets would be recirculated to all members of the pool in a mortality rated distribution (so a 90 year old would get 10 times as much as as a 70 year old . The early death clearly benefits peers and survivors clearly profit. No nasty institution getting in the way (and no capital tied up for regulators) The pool would be open to all comers with no medical requirement

    One for Facebook?

  6. I think this article confirms the major problem of our industry. There are no solutions that meet the aspirations of our customers. Just because investors want a combination of no risk to capital, a decent income and prospects for capital growth, it doesn’t meant there is a solution.

    There are no anti-ageing creams that work, but there’s a whole industry to service the demand for them.

    Likewise, there are no investment solutions that deliver what most investors want, but an industry has developed that manufactures purported solutions. We have have funds described as “low-risk” simply because their prices have historically shown low-volatility, we have bond-based income funds for low risk investors with terrifying redemption yields and the biggest investment scandals in recent years haven’t been offering 20% p.a. returns, they’ve been offering 7-8% p.a. – it’s the easiest way to attract the most money.

    The solution is for the industry is to educate investors properly and explain that risk and reward are inextricably linked. With base rates at 0.5% p.a., investors seeking returns of 5% p.a. or more need to understand the risks they’re running. Marketeers need to be reined in by companies to prevent investors having unrealistic expectations, and marketing agencies need to ensure their staff have at least a modicum of understanding of how their clients’ businesses work.

    Investors are currently facing the looming “disaster” of increasing interest rates, and the effect that will have on bond values and liquidity, but I doubt any of them have the slightest idea their “low risk” corporate bond fund could soon turn into something very different.

    The response to investor demand to have their cake and eat it should be to tell them that they can’t and explain why. Then explain what their options are and allow them to make an informed decision. But I somehow feel our industry will still manage to develop the next “solution” – Secure High Income Trust anyone?

  7. goodness gracious 15th April 2014 at 1:28 pm

    Why, oh why do so many of our brethren chase income? When investing, there is no real difference between growth and income apart from the tax on growth is usually less. With increasing use of platforms, taking regular payments out of funds is now easier than ever. A life bond provides no income, just growth, but it was often the chosen method of providing income. When bonds are bought at par and held to maturity, the risk is only that the company may not be able to pay either the interest or maturity sum. When held inside a fund, it becomes in effect an open ended investment rather than a closed ended one, therefore the interim market values hold great significance to an investor. What concerns me is the low risk quoted refers to the individually held assets within a fund, rather than the overall volatility of the fund. When interest rates rise, interim bond values fall and the interest may not be sufficient to counter this fall for some time, so do I recommend them? Yes, but only as part, often a small part, of a portfolio, because how do I know when this rate rise will start? Inflation is low, business is booming and there is little political will worldwide to raise rates.
    How more or less risky is a corporate bond fund mainly comprising of AAA-BB holdings compared to an equity income fund? What is risk anyway after a 5 year term in equity dominated investments?

  8. According to a very useful Capital DrawDown program I happen to have on my PC, a fund achieving average annualised growth of 5% p.a. (net of charges) will support income at a rate of 7% p.a. for 25 years. Add to that an insurance element against premature fund burn-out (which I wouldn’t have thought need cost very much at all) and you have an ideal superior alternative to a conventional annuity. For those in poor health and thus shorter life expectancy, the rate of income should be better still. Furthermore, life expectancy could be periodically (say every five years) re-underwritten, possibly resulting in an increase to the level of income.

    Surely this is the logical next step in product development and the likes of Prudential, L&G, Aviva and MetLife should be leading the way.

  9. The analysis in US highlights that 5% drawdown is too toppy, so 7% is heroic

  10. As ever, thoughtful observations delivered with clarity, Lucien.

    This ‘industry’ is unlike any other, in that the product that is delivered in exchange for money is, well, Money. Our behaviour within it and around it is different to any other service or product. Money is the only thing that impacts every one of our emotional and physical needs.

    The Money industry’s motivation is to make more of it, by exploiting those impacts. The way the product is priced (ad valorem), the belief in “free money” (rising indices seemingly creating profit out of thin air with no balancing losers), the promise of needs and desires fulfilled all serve to preserve and accentuate moral hazard.

    Most insidious is the fact that money is a primary source of stress. The personal finance industry preys on this, implying that our emotional and physical well-being can only be enhanced and preserved through “Wealth” and its management. Products are developed to present opportunities “normally available only to the very wealthy”, that use arcane arrangements that massage the collective ego of product developers, in order to justify large chunks of the invested money being syphoned into the industry’s coffers.

    Our financial ‘needs’ are simple. Enjoy life now but spend less than you earn. Save the excess for the future. Recognise that our society’s collective goals and risks can be pooled for the greater good – the biggest (and best) idea the industry ever had was life assurance, by the way. ‘Too good to be true’ probably is. Invest in ‘real assets’ as long as they compensate you through interest or dividend. Speculate on ‘growth’ if you are convinced of the value of the assets and the sustainability of demand, but understand the world’s view of value may not prove to be the same as yours. Nothing is certain; recognise that some people seem to be good at managing money, but that’s through knowledge, experience and discipline and not via a gene for clairvoyance. Finally, get together with crowds of people so that your different risks might offset.

    Simple stuff, I guess, but ’twas ever thus…

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