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The third age

It should really be good news that we are living longer. In 1950, around 16 per cent of the UK population was aged 60 or over. By 1980, that had increased to 20 per cent and by 2030 around 25 per cent of the population will be 60 or older.

A boy born in England in 2005 has a projected life expectancy of 77.2 years (81.5 years for a girl). The average figure is the statistic we have in mind when we, if we ever do, think about retirement. “Statistically, having been born in 1940, I expect to live until age 69 and that is how long my pension fund needs to last.”

But that is not how it works. By the time a child born in 1940 reached 65, many of the other children born in the same year had already died which contributes to the average figure.

Retirees and those approaching retirement need to look at the likely life expectancy of others of their own age.

The 2005 baby may only have been expected to live until 77 but a male aged 65 in 2005 could be expected to live for a further 17 years.

Between 1981 and 2005, life expectancy in the UK as a whole increased by four years for 65-year-old men and 2.8 years for 65-year-old women.

As a nation, we have greater life expectancy in retirement. Both our own resources and the state’s will have to support us for longer.

The state’s contribution to our retirement is primarily through the state pension, although if we are living longer, we are also likely to be making increased use of the NHS. In fact, for a whole variety of reasons, the state pension is a very big part of most people’s retirement provision.

The Pensions Policy Institute produced a pensions facts document in February, using data from a wide variety of sources. These figures tells us that, for 2005/06, the average proportion of pensioner income paid from the state, including retirement pensions, disability benefits, pensions credit, etc, was 55 per cent and this figure has remained pretty much constant since 1997/98.

With pensioners living longer and a declining birth rate, the strain is immense on a pay as you go state pension scheme.

According to the Office for National Statistics, already around 19 per cent of the total population is aged over state pension age and that is projected to increase to 21 per cent by 2050, even after allowing for significant increases in the SPA which come into effect before then.

Average pension funds being used to buy an annuity are around £25,000, according to the Association of British Insurers. This is skewed by a number of smaller funds and the fact that many bigger funds are used for drawdown rather than annuity purchase.

This is the background against which a number of providers, including Met Life, Aegon, The Hartford and Lincoln have, over he last two years or so, launched so-called thirdway annuities into the UK.

These contracts, under their American name of variable annuities have been hugely successful in the US and Japan.

In effect, they are a form of hybrid of annuity and drawdown contracts allowing the annuitant to benefit from a guaranteed level of income while still investing in the stockmarket with the potential for growth which would increase the guaranteed income payable.

The product providers expect the concept to go down well in the UK and some plan to use the UK as a springboard into wider European markets. Both Standard Life and Prudential are expected to launch some form of thirdway contract this year.

Expectations of success are based largely on the similarities in the demographics of the US and the UK and Japan for that matter.

Increased longevity, declining birth rates and lack of confidence in what the state will provide are common factors, with the position in Japan being worsened by the lack of any significant movement of people into the country.

The models of third-way products are different from provider to provider as well as country to country. What they have in common is the presence of some form of “guarantee” in the form of lifetime income or availability of capital at some point in the future.

MetLife Europe strategic development and marketing director Dominic Grinstead says: “We prefer to use the phrase ‘pension products with unit-linked guarantees’ rather than variable annuities because we feel that it better describes the range of solutions offered on the UK products and differentiates them from their US counterparts.

“Whatever phrase you use, our research points to the fact that IFAs expect this market to grow substantially in the UK in the near future, not least because they provide a solution to two major problems facing advisers and their clients stock market volatility and inflation.

“We are constantly pushing out the good news about the value of the products and IFAs are keen to find out more about them.”

That seems to be the common view from the transatlantic arrivals. The Hartford key account director Tim Barker says: “We are witnessing the same trends that drove the expansion of the market in the US and Japan, including an ageing demographic that wants to make the most of retirement. The variable annuity market in the US is worth $130bn a year and $50bn in Japan. The UK market is undoubtedly different and does not follow every US trend but actuarial consultancy Tillinghast Towers Perrin estimates that inflows into variable annuity products will reach £70bn by 2016.”

Broadly, the obvious attraction is continued exposure to the market to benefit from the potential for growth while protecting the fund/income from potential downsides.

The cost of these products has been used as a reason for not recommending them. Obviously, the charges for this type of contract will be higher than for investment vehicles which do not protect against downside risk but any form of insurance comes with a premium.

However, as the market matures, the costs are reducing. Speaking after the launch of its new contract, MetLife’s Grinstead said: “The media has often pointed to the charges on these products as holding the market back but the charges are priced for a competitive market and are good value.

“For example, we recently introduced a range of index funds to the choice of investments available to investors in our pension products, which meant that the annual fee for our guarantees, including the annual management charge on the underlying funds, start at just 1.1 per cent. That should represent good value in anyone’s eyes and destroys the myth about high charges.”

The actual cost of the ‘guarantee’ will depend on how robust it is, whether it can be reduced by the provider in any circumstances and what funds the investor wants to utilise.

The current market volatility and, to some extent, the slowdown in the housing market combined with the credit-crunch, which make a reliance on equity release less certain, mean this is an attractive concept for today’s market. The US experience suggests that it is equally attractive in all market conditions so it may well be here to stay.

Assessment of the available contracts is difficult due to the varying models on the market but some key factors to consider will bel How firm is the guarantee?

  • Who finally backs it?

  • What is the financial strength of the provider and any third parties involved?

  • Can the provider ratchet the guarantee down in a falling market?

  • Does the guarantee ratchet upwards in a rising market?

  • How does the cost of similar products compare?

    Cost is being hyped as a key issue by many pundits. In fact, judging by recent launches, costs are falling but clearly a contract with guarantees will always cost more than a contract without guarantees, it is simply a question of a client’s willingness to balance reduced risk against increased cost.

    Variable or third-way annuities cannot be ignored when advising clients at retirement or, indeed, when reviewing existing drawdown arrangements.

    All of the available options must be considered when giving advice, especially at retirement, where it may not be possible to change things at a future review.

    David Ingram is a partner at threesixty services

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