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