For many years an annuity was the only way of converting a retirement fund into a lifetime income. Then, in 1995, the introduction of income drawdown radically changed the picture by making it possible to take an income from the pension fund whilst leaving the rest of the fund invested.
As recently as 2006 the Government spoke of the ‘annuities deal’, saying: “… in return for the generous tax relief on pensions saving, the Government requires individuals to turn their pension fund into a secure retirement income.”
This was over 10 years after drawdown, yet it was still just the junior partner.
In 1995 the relationship between income drawdown and annuities was often that the use of one was followed by the other. Indeed, drawdown was often referred to as annuity deferral.
There was the anticipation that annuity rates might go up and, at older ages, the introduction of mortality drag gave annuities a bit of investment uplift without the accompanying investment risk.
So, the general view was to use income drawdown for a few years for flexibility and then annuity purchase at a later age, taking advantage of flexibility and then making the decision to lock in for certainty.
Now I think the hierarchy has changed as retirement can be a very long time.
Why would anyone lock into a traditional annuity at a low rate at a young age where there is not yet even the benefit of mortality drag?
There is no doubt that the current discussion about annuity value and inflexibility will mean that some individuals consider income drawdown when perhaps they might not have done before.
The investment flexibility offered will certainly be a positive but this does come at the expense of the income guarantee offered by annuities (at whatever level of income).
I do wonder whether the retirement income world is at something of a crossroads, where things might never quite be the same again and consumer outcomes could potentially be more positive.
One of the findings from the FCA thematic review of annuities is that many consumers do not realise that lifestyle/health and even geography can buy them an individual rate which is likely to offer a higher income than the standard rate.
This is correct and the right of everyone to have access to the best rate is impossible to argue against.
But as soon as we move to underwriting individual cases the whole fundamental basis of annuities – that is to say pooling and cross subsidy – starts to go.
Those with poor life expectancy are taken from the annuity pool and this means less cross subsidy and lower annuity rates. More people doing drawdown also leads to the same result.
It is possible that we will move to much more selected underwriting, but at what cost – considerably lower rates for healthier people?
It seems that we took our eyes off the ball and put too much reliance on annuities?
We now need to start filling in some of the gaps between absolute security and absolute exposure to investment. Temporary annuities, third-way products, and investment-linked annuities already exist, and I am sure we will see further development in this area.
For drawdown, we will see the use of target date funds, liability-driven investments and other solutions to de-risk drawdown for smaller, more risk-sensitive funds.
Aside from product development, we will also see improvements in process, such as greater use of information packs and the benefits of shopping around. Consumers must have the confidence that their hard-saved pension funds are giving them the pattern of income that they need for retirement.
Mike Morrison is head of platform technical at AJ Bell