Last week, heading towards the end of this series of art-icles on key aspects of pension drawdown, I illustrated the tolerance to interest rate reductions within drawdown contracts. This showed that, given a stable residual investment fund, the eventual annuity which may be purchased by each £1,000 may remain stable or even increase beyond the level of annuity which could have been bought at retirement date, notwithstanding a fall in interest rates.
In reality, all this simply illustrates is that the negative effect on annuities of falling interest rates is at least partly offset by the positive effect of the drawdown member's increasing age.
This simple juxtaposition of falling interest rates against increasing age presupposes a stable level of investment fund. Of course, this is not always a realistic assumption, especially where the drawdown member is taking a level of income from the contract which is at or near the maximum permitted by the Government Actuary's Department.
Accepting this, I closed last week by noting that the positive effects of increasing age can also be applied to falling fund values. In other words, given stable interest rates from the date of retirement to age 75 – the latest at which a conventional annuity can be purchased – it is possible to identify that the member's fund can fall quite significantly over the drawdown period but still enable a higher annuity to be purchased at age 75 than could have been bought at retirement age.
I gave a simple example and noted that I would conclude this mathematically quite complex but absolutely vital concept by noting the net effect of increasing age, falling interest rates and falling fund value. The table below summarises this situation.
I have worked out the “annuity value” (OK, so it is really the GAD limit and I admit to taking poetic licence but the principle is more important for this article than actuarial precision) of each £1,000 of fund at age 75 against its value at age 60 at different final levels of interest rates.
Even if you do not entirely follow the maths, the important principle should be understood – if interest rates rise, or at least do not fall, then a substantial reduction in the fund can be tolerated before the annuity purchased at age 75 falls below that which could have been purchased at age 60. Even if interest rates fall,a reduction in fund value might still be tolerable.
For example, noting the figures in the table, we are able to specify that the member can tolerate a 3 per cent fall in interest rates and a 16.8 per cent fall in fund with no loss to the eventual annuity purchasing power.
It is worth slowing down here to ensure that we can see how this simplified conclusion has been reached and to note a couple of important caveats in the importance and use of that summary.
First, if we take the annuity rate (again, poetic licence here – the GAD rate) for a male age 60 of £119 per £1,000 at a time when underlying interest rates are 10 per cent, then a fund of £100,000 would generate an annuity of £11,900 a year. If interest rates fell by 3 per cent to 7 per cent by the time the drawdown member had reached age 75, the annuity rate would have nonetheless increased from £119 per £1,000 to £143 per £1,000. In other words, the annuity rate would have increased as the effect of the member's increased age would have been greater than the effect of falling interest rates.
This can be applied to show that not only interest rates but also the fund value could have fallen without resulting in an adverse impact on the eventual annuity. This fall could be to 119/143rds of the original level – a fall of around 16.8 per cent.
As mathematical proof of this conclusion, a fall to 119/143rds of the original fund of £100,000 would result in a fund of £83,200. Applying £83,217 at an annuity rate of £143 per £1,000 gives an annuity of £11,900 – exactly the same figure as the £100,000 fund could have purchased at age 60 at a higher underlying interest rate.
The table also shows other combinations of falling interest rates and falling fund values, summarising what might be called the cross-tolerance of drawdown contracts to both these adverse factors. The main caveats, though, must be acknowledged. In particular, it should be noted that increasing life expectancy would have an adverse effect on annuity rates not factored into these calculations.
Moreover, I have assumed that GAD limits are equivalent to market annuity rates at given levels of underlying interest rates. While broadly true, factors other than interest rates can affect market annuity rates at any given point in time.
Finally, although I have restricted this analysis to looking at cross-correlation of interest rates and fund values to single-life annuities payable on a level basis, the same approach can usefully be applied to other annuity bases including, for example, survivors' pension annuities and escalating annuity rates.
Notwithstanding these words of caution, this approach is surely a more useful and professional alternative to simply recounting to the member or prospective member that there exists an interest rate risk and an investment risk without properly identifying the nature and, in particular, the extent and limits of those risks.
Far too often I have been made aware of IFAs who, seeking to address properly the required risk warnings inherent in drawdown contracts, state in their presentations and reasons-why letters that “falling interest rates will lead to a lower annuity when you reach age 75” or “if the value of your investment fund falls, the annuity you will be able to buy at age 75 will be less than the annuity you could have purchased at outset”.
Could I strongly suggest that, if you are currently using phrases similar to these, you consider being more specific. Perversely, this could simply mean replacing “will” with “may”. This might seem less definite but, when followed by an explanation of the tolerances within the drawdown contract to falling interest rates and fund values, I feel this provides much more accurate and useful guidance to clients.
By the way, although I have been referring only to drawdown contracts over the last couple of weeks, you should be able to identify that exactly the same considerations apply to staggered vesting strategies and phased drawdown.
Next week, on to a valuable discussion not just about identifying and quantifying the nature of investment risk but, more profitably, about how to restrict or reduce that risk by the use of quite simple but very effective investment portfolio planning strategies.
Regular readers of this column might be able to anticipate the direction of my next article when I mention the word “correlation”.
SRCE: Money Marketing,
SCTN: Pensions Brief
HDLN: Pump up the volume
SBHD: Our panel of experts look at survival in the market, the future for annuities, admin costs and money laundering.
Are there any other strategies for survival in the current pension market outside of “be big or be niche”?
Clarke: Be good! If we are moving to a market where products are very similar through charge caps, access terms and other aspects of the regulatory environment, then differentiation can still be achieved through how a company behaves. This will come not only through basic service standards of speed and efficiency but also the ways in which providers act to build trust and understanding in their customers.
With level charging, providers will find it much harder to shoulder the cost of policies which lapse after only a couple of years. A long-term product requires long-term attention to build a long-term relationship with the customer. Approaches such as the Raising Standards initiative of the ABI will do a lot to ensure that this is the case.
Naismith: No. There is going to be so much pressure on costs in the mass market that only those who can sell big volumes are going to make profits. Niche markets, where bells and whistles are as important as cost, will offer reasonable profits on smaller volumes.
Craig: To be a participant in the main pension markets, a provider must be able to operate successfully within the 1 per cent charge cap across the range of their pension products – not just stakeholder.
This will require significant scale to enable the required increases in productivity, and therefore reductions in unit costs, to be achieved.
Further extension of stakeholder charges to the more specialist pension markets will mean that even niche providers will have to face up to these challenges.
Will normal annuity rates plummet if annuitants are encouraged to shop around for enhanced and impaired rates?
Clarke: Normal annuity rates could be expected to fall somewhat but are highly unlikely to plummet. Overall, the rates charged for a portfolio of business cover the risks involved (that is, that someone lives longer than expected) so if a proportion of these are charged less (that is, by giving an enhanced annuity rate) then the remaining portfolio will normally be charged more.
It is important that we learn from the strength of the debate about insurers' use of genetic test information. If we are to introduce more widespread underwriting of annuities, it is essential that the issue is treated sensitively, with customers given a clear and simple explanation of how those underwriting decisions are made.
Naismith: Removing those with shorter life expectancies from the normal annuitant pool inevitably increases the cost of annuities for those who remain. This has already happened with income drawdown.
However, since unhealthy people are already more likely to include spouse's pensions and possibly longer guaranteed periods, the effect may not be as dramatic as some expect.
Ultimately, too, a healthy life will still get a fair deal from an annuity. In the past, they have got a very good deal because they were subsidised by those who were unwell.
Craig: The annuity concept is dependent upon a pooling of risk, with those who die early cross-subsidising those who live longer. Annuity rates are affected by a number of factors, including long-term interest rates and expected future mortality. In theory, if every individual with a poor life expectancy purchased an enhanced or impaired life annuity, then the rates available to those with a higher life expectancy would worsen. In practice, it is still too early to tell whether there will be a significant impact on conventional annuity rates.
Have admin costs increased under the post-April 6 tax regime?
Clarke: It is very difficult to be precise about how the move to stakeholder has affected admin costs as it is still early days and business volumes are still quite volatile.
It is fair to say that stakeholder has exerted a strong downward pressure on admin costs but many of the business developments used to streamline these costs, such as electronic document management, direct booking of business via laptop computers and internet facilities, would have been brought in to back-office processing anyway and may have just been precipitated a little earlier by stakeholder.
Ian Naismith, Head of marketing and sales (technical),Scottish Widows. Michael Craig, Marketing development manager, Standard Life Martin Clarke, General manager (marketing),Co-operative Insurance Society