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Variable solution

Ben Pollard and Susan Stock, consultants at the Tillinghast business of Towers Perrin, talk about the virtues of the variable annuity

One of the key financial questions today is how to save and invest for retirement and in retirement in a way that achieves the right balance between peace of mind and stock-market exposure.

This is of particular importance to the baby boom generation who are now at or near retirement but are faced with a positively underwhelming set of product choices. Products that used to offer a solution in this area, such as with-profits business or immediate annuities, are now no longer available, have lost credibility or are unpopular.

New solutions are now being sought and one such product that has been successful in the US and Japan is the variable annuity. In the US, variable annuities are commanding net assets under management of $1.3trn and in Japan they have accumulated $80bn in assets under management in just five years.

It is important to note this new US-style variable annuity bears little resemblance to the traditional annuity recognised in the UK.

It is best described as a conventional unit-linked investment product, underpinned by one of four basis types of guarantee:

  • Minimum accumulation benefit, where funds are guaranteed to accumulate to a certain amount over a certain time.
  • Minimum withdrawal benefit. Where from a fixed point in the future, it is guaranteed that regular withdrawals can be made at a specific level, even if the fund itself subsequently runs out of money.
  • Minimum level of income, where it is guaranteed that a certain level of income can be purchased using the fund at a particular point in time.
  • Minimum death benefit, where a named beneficiary is provided with a specified sum in the event of the insured person dying.
  • By combining and tweaking these four simple building blocks, an offer can be designed that meets clients’ personal needs – and they give the provider flexibility in future product design as the target market profile changes. This has been demonstrated in the US, where more than 40 different types of guarantees have been produced in the past 20 years.

    To succeed in the variable annuities market, confidence must be established that this type of product avoids the weaknesses of its predecessors. The design must bear scrutiny from a wide audience, including regulators, distributors and customers, who may be nervous and sceptical about financial solutions with guarantees.

    To help with this, variable annuities distinguish themselves from their predecessors in one major dimension – transparency. The guarantee is transparent and, except for some of the more complex versions, straightforward to understand and explain, as are the costs charged to the customer.

    For the provider, the way the guarantees are provided for and managed are also transparent to management and regulators.

    The historic lack of transparency – when guarantees were bundled into products with implicit charges – means that customers are not familiar with the idea of paying for a guarantee.

    Part of the new product development and marketing process will therefore be choosing how to package any charges and surrender values and how fairly to represent them.

    For providers, there are multiple risks to address to manage the book of business prudently.

    To achieve transparency, the first step is to be clear about the degree of risk that the management has appetite to carry on its balance sheet and the amount and nature of the guarantees and risks that should be hedged.

    The provider then creates the hedging programme and performs ongoing oversight of the programme’s execution. An important prior step is the identification of how the risks associated with variable annuities arise from the product design and how they can be mitigated.

    Dynamic hedging solutions can mitigate some of the design risks but there are many other types of risks to consider. The good news is that the hedging techniques have been fully developed and tested in other markets and have been successfully imported into Europe.

    The first step for companies considering launch is to obtain a thorough understanding of the potential market segments – age and net worth, pre-retirement, near-retirement or post-retirement, mass affluent or SME owners, investment preferences and attitude to risk.

    This market segmentation helps establish the type of product to offer and the potential volume of sales that may be achieved. There is much experimentation and careful design work to be done to adapt US designs to work well in the UK.

    Supporting the sales process will be a critical issue for providers and distributors alike. Variable annuities are a new and for some designs a relatively complex proposition. In choosing the product’s final structure, providers should consider the distribution route being used and the tools that can be made available to intermediaries to help advise consumers about the product.

    Getting over this barrier of understanding is a key requirement for launching variable annuities.

    Interactive technology is available to intermediaries that enables customers to compare guaranteed and non-guaranteed investment vehicles under multiple investment scenarios, in easy-to-understand, graph-ical formats.

    With this type of tool, it is possible to meet the challenge of explaining to the end customer the risks involved and how the guarantee works.

    The same understanding challenge needs to be met in-house at providers. Senior management will want to be confident that the prod-uct will succeed in both market and risk manage-ment terms.

    Above all, products should be carefully tested with IFA’s – more carefully than normal – and the investment hedging programme demonstrated to be robust.

    There may seem to be a lot of hurdles to clear in launching this type of product. Initial caution with guarantees should be countered by the existence of proven techniques in hedging applications and interactive distribution tools.

    Given the growing number of people facing retirement and living longer than previously anticipated, new and innovative products such as variable annuities present an offering that represents the best traditions and skills of our industry in meeting the long-term needs of our customers and so merit serious consideration.

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