Annuity providers have found themselves at the centre of a political storm as society wrestles with fundamental questions about the behaviours driven by modern day capitalism.
How much profit is “acceptable”? Are the short-term interests of shareholders favoured over the long-term interests of customers? And what, if anything, should the Government do about it?
On the first point, profitability is difficult to measure in insurance contracts because it is based on an actuary’s best guess of life expectancy – which could be wrong. So when an insurer turns a pension pot into an income for life, it must price in the “risk” that people will live a lot longer than expected.
As one actuary at a major insurer said to me recently: “One man’s profit is another man’s risk premium.”
The key issue here is not, in my view, the behaviour of pension providers. The majority are shareholder-owned behemoths whose sole purpose is to pay a dividend to those shareholders – that is the nature of the UK market.
One of the main benefits of this profit-driven model – in theory at least – is innovation. And the annuity market has not been without innovation, evidenced by the stock market listings of enhanced annuity specialists Just Retirement and Partnership this year.
But some are now beginning to question whether the benefits of capitalism in the annuity market outweigh the costs.
If that is indeed the case – and the evidence is far from clear – the Government has two obvious options to improve the market. The first is to tackle the problems on the demand-side by promoting the open market option (surely there is room in the Money Advice Service’s £77.5m budget for a TV campaign?) and the importance of seeking independent advice.
Policymakers could also investigate the role of defaults here, and ask whether behavioural nudges can be hard-wired into the system to guide people through the annuity buying process.
The second more radical option is to look at supply-side reforms. The Department for Work and Pensions has dipped its toe in this area by proposing an easing of regulations that prevent collective defined contribution schemes being set up in the UK.
In a CDC scheme the annuity is provided from the funds of existing members, rather than being bought from an insurance company. In theory, this would benefit scheme members through a reduction in costs and the ability to invest in risk-seeking assets for longer.
There remains an active debate about how much more money savers in a CDC scheme would receive in retirement, however, with Aviva head of policy John Lawson challenging claims by the RSA that people in collective schemes could see a 39 per cent uplift in their retirement income (you can read John’s arguments here).
Furthermore, a shift to CDC would be a long-term project and require the collective buy-in of employers.
Another option vaguely flagged in the Financial Services Consumer Panel’s report into the annuities market would be to create a state-funded body, similar to Nest, to provide a benchmark for good quality annuity provision.
However, Nest was formed because the private sector could not guarantee it would serve the entire auto-enrolment market. The same cannot be said of annuities, where the arguments centre on the amount insurers are pocketing in profit rather than their willingness to serve the market.
This option would also require massive upfront and ongoing costs that would have to be picked up by the taxpayer, without any guarantee of a meaningful return on their investment. Furthermore, creating a lumbering state-run annuity provider to keep the private sector in check doesn’t feel like a progressive solution to the problem.
The reality is there are no easy answers here. The role of the insurance industry in providing pensions is deeply embedded in UK financial services, so a structural overhaul is likely to be messy, complicated and drawn out.
The current annuity debate is healthy and necessary, but at some point politicians and the industry will need to consider whether any of the proposed “solutions” will materially improve outcomes for people approaching retirement.
Tom Selby is deputy head of news at Money Marketing – follow him on Twitter here