Unit-linked guarantees: A costly price to pay or value for money?

Retirement plan-pension-report

It is not surprising the retirement landscape has shifted following the seismic upheaval in the pensions market.

Pension freedoms have created the space and opportunity for new products to emerge and for older products to be revisited. This is the case with unit-linked guarantees, products which in some circles carry a degree of controversy.

Not everyone in the industry welcomes the return of these hybrid policies – also known as guaranteed drawdown. Some argue they do not provide value for money for consumers, and are of more benefit to those selling or running these plans.

Speaking at a Money Marketing roundtable debate on the pros and cons of these specialist retirement products, Tisa policy strategy director Adrian Boulding said he does not object to guarantees in theory. But in practice he is concerned they do not always offer value for money.

“Guarantees tend to work best over shorter periods of time, where they have a clearly defined purpose and the consumer has a clear need for them. But I tend to be more sceptical whether consumers need long-term guarantees embedded into products.”

Boulding argued an insurance product bolted onto an investment scheme can be expensive, and that advisers and clients have to ask themselves two key questions: Does the customer really need this protection, and is this the most cost-effective way to provide it?

Retirement Intelligence director Billy Burrows believes it is clear many customers have a need for this type of guarantee.

He said: “Unit-linked guarantees have a very good customer proposition, particularly for savers in the “squeezed middle”.

Burrows described the pensions market as falling into three segments. He made the point that those with more generous pots (typically upwards of £250,000) are already well serviced by the financial services industry, and there was little the industry could do for those with very small pots.

But he said unit-linked guarantees may serve as a useful tool who fall between these two camps.

“Prior to the changes these savers may not have had a large enough pension to go for traditional drawdown, but now they are interested in the opportunities offered by pension freedoms.

“They don’t want to hand over the entire pension fund to an insurer and lock into an annuity at a historically low rate. But while they like the idea of more flexibility, they are also telling us they would liked to secure some income, at least to cover essential expenses.”

He added: “Unit-linked guarantees offer a way to navigate a third way between annuities and drawdown for this group.”

But not everyone agreed unit-linked guarantees were the best way to provide this balance.

Wingate Financial Planning director Alistair Cunningham argued the same effect could be achieved, at a lower cost, through a combination of a traditional annuity alongside a low-cost drawdown plan.

Cunningham said: “You can ensure essential bills are covered by the state pension and a smaller annuity, with discretionary spending covered by their drawdown income, which offers the potential for future growth.”

He pointed out the income secured under a unit-linked guarantee is less than the equivalent paid by an annuity. For example, a £100,000 pension fund would secure an annuity income of around £5,500 for a 65-year old. If this fund was invested in a unit-linked guarantee the policyholder would secure a guaranteed income of around £4,500 a year. This guaranteed income would rise, and lock in at a higher rate, if the fund subsequently increased in value.

Yellowtail Financial Planning managing director Dennis Hall said his main objection was the cost.

He said: “If a customer is paying around 100 basis points for advice, then paying 100 basis points plus for a guarantee, plus paying fund management charges, this can be a real drag on performance.”

Hall argued this can dent the potential upside, potentially quite significantly, so made him question whether guarantees were worthwhile.

He said for many cost-conscious customers it is likely to be question of choosing between advice or a guarantee.

His view was clients were better served long-term with a carefully chosen investment strategy, regular monitoring of their funds and a more honest conversation about the consequences of falling markets – rather than resorting to an expensive guarantee.

“Our conversations include input from clients about tightening belts in bad times. If customers don’t want to take on the risk of a falling market, then perhaps they shouldn’t be in drawdown contracts.”

He conceded having a secured minimum income may mean some ‘medium-risk’ investors could afford more equity exposure, but argued he would not expect the additional upside this could produce to outweigh the higher cost of the guarantee.

Aegon UK distribution director Gavin Casey said it was important advisers do not narrowly look at just the cost of the guarantee, as they also need to look at what value these products deliver for clients.

“You could compare it to the cost of buildings insurance. This might seem a high cost to pay if your home never burns down, but it will look like terrific value for money if it does.

“Unit-linked guarantees offer similar protection, but here it is about preventing a pension from ‘burning out’, leaving people with nothing to fall back on later in retirement.”

He added: “I don’t think the guarantee is expensive at all. It reflects the real risks people are taking by keeping their pension fund invested.”

He said many people underestimate these risks,  possibly due to a relatively benign investment climate in recent years, and GAD rules which used to restrict what could be withdrawn from these plans.

But he argued with GAD gone and pension freedoms opening drawdown to a wider audience – many of whom may not get advice – there is the serious risk that many may run out of money, particularly if markets turn sour.

AKG Financial Analytics head of communications Matt Ward agreed.

“Just because we haven’t had headlines about how markets have ravaged people’s drawdown plans, doesn’t mean we won’t in a few years, particularly with the ‘new generation’ of drawdown customers that seems to be emerging as a result of pension freedom reforms.”

Casey said: “A unit-linked guarantee offers clients the security of knowing money will roll into their bank account each month. At the same time they still have a fund, and the potential to increase their pension if markets rise as well as the flexibility to switch products at a later date.”

He conceded these products will not be suitable for everyone, and he expected most clients would only invest part of their pension into a unit-linked guarantee. “When you’re assessing the costs it’s important to remember that the 1 per cet charge, for example, isn’t necessarily on the whole fund – just the portion invested in this unit-linked guarantee.”

He said he agreed with the point made by Cunningham and Hall that taking a combination of annuity and drawdown may be a cheaper option on paper. But Casey pointed out this does not give consumers the flexibility to alter their arrangements should their circumstances change.

“Yes, you might be better off in the long run with this arrangement, but only if you pick the right shape of annuity to start with. We know divorce rates among the over 60s are rising – and many will marry again, either after divorce or bereavement. And there are a whole bunch of illnesses that strike later in life.”

With a unit-linked guarantee there is the option to switch to an ill-health annuity, for example at a later date.

Casey said there was a cost to this guarantee, whether it was higher charges than a low-cost drawdown plan, or a lower secured income than an annuity. “But we think this cost represents good value. We don’t make vast profits on these plans. However, I appreciate this this may not be everybody’s view.”

The panellists agreed that ideally unit-linked guarantees should be advised products, but recognised in the new pensions world this may not always be the case.

Ward said: “We can’t underestimate the changes that are happening in the pensions market. It’s clear consumers are excited about the new pension freedoms, but they also want certainty. Just look at how quickly the new pensioner bonds sold out – despite the fact no-one is supposed to trust the Government these days. People clearly liked the peace of mind these products offered.

“Those retiring today need to weigh up a whole range of additional risks – from investment strategies to mortality – that weren’t an issue for those retiring a generation or two ago [who tended to have final salary schemes or higher annuity rates]. If providers, asset managers or advisers can help take some of these risks off the table for more cautious investors this is to be welcomed.”

He said unit-linked guarantees are not the only way to achieve this, but having a wider choice of products could only benefit consumers.

But Ward stressed that advisers and providers need to ensure  customers clearly understand the benefits, risks and costs of these products – whether people are buying annuities, drawdown plans, unit-linked guarantees or a combination of all these different products.