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The meaning of guarantees

The ’cost’ of guarantees is used as a stick to beat the industry but with reduced risk there must be reduced returns

Colin Bell
Colin Bell

During these times of economic uncertainty and stockmarket volatility, the true value of guarantees has never been so important.

It is the right time to explain the true value of the guarantees provided by variable annuity products and also explain why the “excessive cost” argument levied by variable annuity detractors does not stack up.

Without question, the guarantees are valuable – arguably more so now than ever before, which is why there is an explicit charge for them. This charge is used to operate a comprehensive risk management programme which ensures that the product provider is able to meet the guarantees.

The main driver of the cost of providing these guarantees is the price of purchasing hedge assets in the capital markets. Providers of variable annuity products are constantly buying these assets to keep up with changes in economic conditions and to reflect the exact profile of business they have on their books. This means that as new customers join, providers will purchase more hedge assets.

The price of these hedge assets changes on a daily basis and depends on market conditions. In bad times, such as when equities are particularly volatile and/or long-term interest rates are particularly low, it costs more to buy these hedge assets than it does in good times.

This means the cost of providing guarantees for a cust-omer who invested in 2007 could be significantly different than the cost of providing the same guarantee for a customer who invested in 2009.

The net result of both the guarantee and the associated charge for the guarantee is to change the risk/return dynamic of the investment fundamentally. It is not technically a cost, no more so than investing in cash rather than, say, equities has a cost – that cost being lower expected returns than equities in exchange for lower risk.

The fact that long-term interest rates have fallen means that the expected long-term returns are lower now than they were before. Long-term interest rates are one of the key drivers of value for a customer, as they represent an alternative investment. For example, if long-term interest rates were extremely high, for example, 10 per cent, then a guarantee of 5 per cent income would not be particularly attractive. But if long-term interest rates in the UK were as low as 2 per cent, then a 5 per cent income guarantee would be extremely valuable.

Additionally, the fact that equity markets are volatile means two things. First, when equities fall, they are falling by bigger amounts. This increases the likelihood of a unit-linked product being exhausted by income payments. This means a guaranteed payment or income for life has more value.

Second, when equities rise, they are rising by bigger amounts. This increases the likelihood of a step up in the guaranteed income. Again, this increases the value of the guarantee.

Unit-linked guarantee products should really be considered an alternative asset class with lower risk and, therefore, lower expected returns.

Because these products still allow you to remain fully invested, the reduction in expected returns manifests itself in a very transparent guarantee charge.

For too long, the explicit “cost” of these types of guar-antees has been used as the proverbial stick that is used to beat us over the head and say “these products are too expensive”.

The reality is that they are not, it is simply a case of explicitly and transparently demonstrating one of the most fundamental laws of economics – with reduced risk, there must be reduced expected returns. If there is not, then you know something is very wrong.

Colin Bell is product director for unit-linked guarantees at Aegon

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Comments

There are 2 comments at the moment, we would love to hear your opinion too.

  1. In general, I agree with the sentiment of this piece – ie you get exactly what it says on the tin from the guarantee charge – and a variable annuity (VA) should not be discounted on the level of charge alone. For starters, there are several providers in this market now and this should drive cost competition. The cost of the gtee should only be part of the analysis undertaken. I would expect the plan to be used where investment growth is a desired outcome for the client. VAs are unlikely to be used merely to access the other key benefits of drawdown, ie death benefits and income flexibility, because a lifetime annuity with annuity protection death benefit lump sum attached, an investment-backed annuity or a fixed-term annuity will offer either one of these or a combination of the two with limited or no investment risk. So, if the client is after investment (and therefore income) growth then an analysis needs to be undertaken on whether this is likely to be achieved. As well as the cost of the guarantee, the asset classes on offer, the funds available and the amount one can put in growth assets such as equities needs to be assessed. On top of this, the client will want an income that will actually meet the retirement needs and the income a VA offers is often lower than its rival products. Should the lower income be acceptable, what upside can be expected? If say 0.5% trail is being taken, charges could range from 2-3% depending on what equity exposure is selected. So if 4% income were taken, in simple terms the fund would need to return 6-7% to ‘stand still’. This may be difficult year-on-year where the funds specified for use with guarantees are limited (some VAs only allow tracker funds), asset class access will be restricted and a cap on equity will be placed upon the fund. And what if the underlying investments fall by 10% in a year (not unrealistic in a 60% equity backed portfolio)? Another lot of income and charges will mean that the fund would need to do around 30% in the following year to get back to where they started from. Again, investment restrictions will make such a recovery less likely.

  2. Notwithstanding the unusually severe falls suffered by Bond and Gilt funds in 2008, experience on the road suggests that a portfolio with an equity content of more than 30% to support Income DrawDown is a recipe for trouble. If the value of the portfolio falls badly just after the date on which the level of income which may be drawn has been reset to a higher level than before, the rate of capital depletion will accelerate. Volatility in such a context is dangerous indeed and the result may well be a sharp reduction to income at the following review date.

    There is no magic recipe for extracting a quart from a pint pot and, though underlying guarantees can be reassuring, if their cost is such as to render the level of income from the product uncompetitive by comparison with a conventional annuity, notwithstanding the unavoidably uncertain possibility of higher income at some unknowable future date, that has to call into question the benefit to risk ratio of many of these third way retirement income products.

    Yes, there will always be demand for products with guarantees, but what the industry needs to be striving to design is products incorporating the lowest possible likelihood of those guarantees being called upon and therefore the lowest possible cost of providing them. I’m continuing to turn over in my mind how best this can be achieved.

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