A paper presented to the Institute of Actuaries last month marks a major step forward in the evolution of annuities. Entitled, Reinventing Annuities, the report makes a strong case for annuitisation.
Annuities work on the basis of pooled insurance. Those who die before their average life expectancy subsidise those who live beyond it. The case for annuitisation is equally simple. Without longevity insurance, there is an unacceptably high risk of running out of assets before death. I believe annuities are the most cost-effective way to provide this form of income protection.
The problem is that the magnitude of this risk is not fully understood by customers, financial advisers or even some of the providers of the current range of retirement income products. As life expectancy increases, this risk gets ever greater.
The report put before the institute on January 16 blows the whistle on this very real and growing danger. It contains some sobering facts. Individuals who reach age 60 in 2001 are most likely to live to 86 for men and 89 for women. Over 25 per cent of men are expected to reach 90 and 25 per cent of women are expected to reach 94. Without annuitisation, most people will outlive their assets by two years. Of even greater concern is that 25 per cent of people retiring will outlive their assets by six or seven years.
The authors are keeping their powder dry on the issue of the abolition of compulsory annuity purchase by age 75. But it is clear that if the requirement for compulsory annuity purchase is removed, the need for retirement income advice will become far greater than at present.
The prospect of people in their 80s having to make sophisticated and worrying investment decisions when faced with a 50/50 likelihood of running out of assets is one that the regulators will take seriously.
The report contains a raft of evidence in favour of annuitisation. For example, by comparing the equivalent additional growth necessary for a non-annuitised fund to keep up with an annuitised fund, it concludes that for most people it is financially advantageous to annuitise well before they reach age 75.
Income drawdown has exposed the problem of mortality drag – the additional return that a non-annuitised fund must achieve to keep up with an annuitised fund. This ranges from under 1 per cent at age 60 to about 4 per cent for males and 3 per cent for females at age 75.
The report brings a new dimension to the annuity debate by highlighting the rapid acceleration of mortality drag beyond age 75.
The additional return required by age 85 reaches a staggering 13 per cent for males – and this from the investments of elderly folk whose attitude to risk is becoming more conservative by the year.
Why have annuities had such a bad press? The great advantage of annuities is the high degree of income security they provide. However, for those who are fortunate enough to be in a position to take a degree of risk with their retirement income, annuities have appeared inflexible.
Comparing annuities with the income drawdown products that are available to those with bigger funds of £250,000 or more has highlighted this inflexibility. Drawdown does not offer the security of income for life but it does allow the retiree to vary investments and income during retirement and preserve their capital sum.
It is the desire to pass on funds to our children that confuses the issue for many of us when it comes to buying an annuity. For some, the emotion of possibly losing the fund on early death has proved more powerful than the fear of living on to become a burden on our children. But it needs to be appreciated that wealth accumulated within the pension environment is for retirement income provision and that inheritance planning should be focused on non-pension wealth such as Isas and domestic property.
From the point of view of the retiree's family, the chance of receiving an inheritance on their early death must be balanced against the need to provide support for them if they survive after their funds have run out.
By not annuitising, in effect, you are relying on self-insurance. By annuitising, the problem is dealt with by commercial insurance.
The paper also turns the spotlight on three other perceived weaknesses of annuities – lack of transparency, income inflexibility and investment inflexibility.
The benefits of mortality cross-subsidy have been seriously undervalued because they are hidden in the workings of traditional annuities. The reinvented annuity would make the cross-subsidy visible to all through a system of “survival credits. As the report puts it: “The annuitant will enjoy a lifetime tenancy of the fund, forfeiting it on death but receiving survival credits while alive.”
This is a particularly attractive feature of these new proposals as it turns a whole attitude on its head. Retirement in the UK has for too long been viewed as the period after you work and before you die. This mindset is inappropriate to the new era of increased longevity, where retirement is increasingly seen as the lifetime opportunity you have worked for.
The concept of annuitisation is more readily embraced by those not obsessed with dying early but instead preparing to live long and active lives, confident in the knowledge that they will not out live their retirement assets.
Income inflexibility is another feature of traditional annuities that has received criticism in the past. The annuity provider, not the annuitant, determines the starting income. Once in payment, the annuity is either level or escalates according to pre-determined criteria, for example, RPI, fixed increases or, in the case of with-profits annuities, by the addition of bonuses.
The customer has no direct control over income. Here, the report argues for annuities that enable the annuitant to vary the income taken at any time in a similar manner to that available through income drawdown.
The report also tackles investment inflexibility. Most annuities invest in fixed-interest stocks that enable the provider to predict and guarantee the amount to be paid for the rest of the annuitant's life. Given the prospect of increased longevity, some exposure to equity investment is probably more appropriate for those who can live with the additional risk.
With-profits annuities offer exposure to equities and property, as well as fixed interest, but do not give the flexibility to switch funds in the future. The report advocates “greater freedom to choose optimally performing assets and vary this choice during retirement to reflect any change of attitude to risk and reward and in financial circumstances”.
Armed with this new evidence, an annuity's guarantee of an income for life looks more valuable than ever.