The role of guarantees post-pension freedoms

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Hybrid or blended retirement products which offer a combination of secured income and drawdown benefits are set become a feature of the post-pension freedoms market.

At our Money Marketing roundtable debate, experts discussed how this market might develop and what safeguards should to be put in place to protect consumers.

AKG Financial Analytics head of communications Matt Ward said: “We have not had full pension freedoms for very long – but it’s clear there needs to be more innovation and more choice for consumers.

“There seems to be demand from consumers for products that sit between an annuity and drawdown plan – and we’re starting to see some providers launch products in this space. I’d expect the choices to widen over the next few years.”

To get an idea of how the UK market may develop Ward said parallels could be drawn with other countries.

“The US, for example, has always had a more ‘flexible’ pension market”.

He explained there has not been the same reliance on a secure pension income there.

However, unit-linked guarantees which can offer more security to pensioners have become big business in recent years.

Aegon UK distribution director Gavin Casey said the market in the US is now worth around $140bn a year. He has spent what he calls ‘windshield time’ driving across different states to visit US-based advisers.

He said: “Clearly there is more of a developed market for unit-linked guarantees in the US than there is the UK. But when you talk to advisers out there, what strikes you is how open they are to changing the terms of the guarantee for consumers, as their circumstances change.”

Casey said unit-linked guarantees are not a one-off purchase in the same way an annuity is, and in the US There is more of a market for advisers to help people shop around for the best value guarantees, reduce or increase these guarantees or switch to other products, like fixed-term annuities.

He questioned whether the the market for unit-linked guarantees in the UK could develop along similar lines. He said: “People may not want to, but many stop working at 65. Getting a unit-linked guarantee allows them to hold off making a irreversible decision on their retirement income for a period of time while they reassess their options, because they know their circumstances may change.”

Others said there are also lessons to be drawn from Australia, which introduced its own pension freedoms a number of years ago.

Tisa policy strategy director Adrian Boulding said the Australian example does not necessarily show unit-linked guarantees will prove to be popular over here.

“What we’ve seen in Australia is people are consuming their pension pots earlier in retirement, when they are fit and active and able to enjoy spending this money. Later in life they fall back on other sources of income – be it a guaranteed final salary pension, or the state pension.”

As a result there seems to have been less emphasis, or concern – from either Australian consumers, or their advisers – about guaranteeing pension pots for life.

Boulding said: “There is the assumption that they will run out of money when they are older. It doesn’t seem a coincidence that pension freedoms were only introduced once plans were finalised for a more generous state pension.”

It remains to be seen whether clients are prepared to pay for guarantees that ensure their pensions will not run out, or opt instead to make the most of the pension reforms, with just a shrug that if they live longer than expected they will have to live on just the state pension.

Ward said rather than the UK following examples overseas, innovative products being developed here may be adopted elsewhere.

“It’s interesting that both the US and Australia are moving from a more flexible pension system to one that offers consumer more secure income in retirement. We are going in the opposite direction – from an annuity-based system to one that now offers more flexibility. Perhaps some of the hybrid products being developed here to meet consumers’ needs could be portable elsewhere.”

Unit-linked guarantees have of course been available before. But poor sales, and difficult pricing these guarantees after the credit crunch meant these products were subsequently withdrawn.

Yellowtail Financial Planning managing director Dennis Hall said he had concerns that similar problems could occur if market conditions worsened again.

“We’ve had unit-linked guarantees before, and not just in the pension market. But when the market goes bananas, they get pulled – just when people most need them.”

Boulding added: “The problem isn’t just that the price of this protection goes through the roof. The problem for providers after the 2009 financial crash was they couldn’t buy this protection in the market at all.”

So how would the new unit-linked guarantees sidestep these problems?

Casey said providers were now far more acutely aware of these risks, having lived through the previous market upheaval. “The providers of unit-linked guarantees in the UK all have substantial operations in the US, so are experienced in this market.

“Pre-crisis there was much more of a relaxed approach, with some providers taking on risks that were not hedge-able. We now err on the cautious side, as you’d expect, and fundamentally only invest in indices where you can readily buy that sort of protection.”

For example, he says the Aegon products have moved to being FTSE 100-based, rather than FTSE All-Share, as it is easier to hedge this index.

He added: “The cost of this counterparty risk does vary, but it is for us to manage this risk, not the consumer. Once you’ve bought a unit-linked guarantee this is a known cost. We would only vary our pricing for new customers.”

Wingate Financial Planning director Alistair Cunningham said he did not particularly favour the FTSE 100 as an index, as it was heavily skewed towards larger mining and banking companies. “This seems to be letting the asset allocation be driven by what is hedge-able rather than what is the most efficient portfolio.” He said he feared this would have a negative impact on performance so the ‘true’ cost of this guarantee may be more than the upfront 100 basis points.

Casey argued this was missing the point. “Our policyholders are less interested in relative performance. Yes, if they’d been in a straight drawdown plan a with a far wider investment choice their fund may have grown more over a 10-year period (although there’s no guarantee of this).

“Instead our clients are interested in the absolute sustainability of their income. They want to know their money won’t run out – while also hopefully getting some upside as well.”

Retirement Intelligence director Billy Burrows said in the past guarantees have been more generous, which may explain why they became difficult to underwrite as markets changed.

He said: “The levels of income guaranteed now may look less generous when compared to a level annuity but this ensures the income is sustainable – as well as providing flexibility and potential for future growth.”

Of course, advisers are concerned that rather than providing ‘the best of both worlds’ there is the risk that unit-linked guarantees end up delivering the worst of both. If markets fall, the higher cost of the guarantee may drag down performance when compared to a typical drawdown plan. In such markets the ‘secured’ income level is unlikely to grow significantly, which could mean clients have less income than they would have got from a traditional annuity.

Boulding added: “There is a risk this could be another payment protection insurance scandal – with people not understanding how these products work then coming back a few years later for compensation when they realise they’d have been better off with an annuity.”

Ward said: “This highlights why the industry needs to communicate better with customers and invest more into consumer education – particularly around retirement issues.”

But the panellists agreed this was an uphill struggle. Hall said this process should start “well in advance of retirement.” And Cunningham added: “The average man in the street doesn’t understand how annuities work, let alone how counterparty risk operates on a unit-linked guarantee.”

Burrows added: “This is why advice should be an integral part of the sale of unit-linked guarantees. People say they don’t understand money, or inflation risks or longevity, but they are not stupid. It’s a question of framing the right questions and understanding their objectives.

“These products aren’t right for everyone, but they can play a role in squaring the circle when it comes to people’s need to have a secure income, as well as some exposure to equities to ensure their pension isn’t eaten away by inflation.”