Here's a brain-teaser. Suppose that a client comes to you, the IFA, with a with-profits pension policy which they have been paying into for the last 30 or 40 years. Very soon, they expect to reap the benefits of all that thrift when the policy reaches maturity.
The client, however, is extremely perplexed. An accountant friend of his has calculated the value of his benefits under the policy. If he stays with the life office and buys a very specific annuity from the same life office, with no alterations to the frequency of payment or the guarantee period, the total value of his benefits amounts to £16,000.
But if he chooses to buy his annuity elsewhere or even just to change the frequency of his annuity payments from quarterly to monthly, the value of his savings drops. The same policy that was worth £16,000 is reduced in value by more than a third to just £10,000.
The client wants to know how the value of his policy can alter so dramatically simply because he chooses to buy an annuity from a different provider. Surely, he asks, the whole point of the open market option is to ensure competition bet-ween annuity providers? Surely, the Omo is meaningless if he loses so much value by exercising it and surely the value of his policy should not be altered by his decision to have his annuity paid monthly rather than quarterly?
Surely, in other words, his policy should be worth the same, no matter what he chooses to do with it?
Answer – he has a policy with a guaranteed annuity option. By the age of 65, he may have built up a share of the life insurer's funds (known as his “smoothed retrospective asset share”) which, in cash, is worth £10,000.
If the guaranteed annuity rate is, say, 11.11 per cent and the current market annuity rate is 6.94 per cent, it gives an uplift of 60 per cent. In other words, the total value of his benefits under the policy is boosted by 60 per cent from £10,000 to £16,000.
But he loses that extra value unless he goes for the guaranteed annuity option. Against all principles once held dear, he only gets the full value of his benefits under that option. The option, in other words, is the only option that makes financial sense. The option, to put it bluntly, is no option at all.
The above description app-lies to the practice of a number of many well known life insurers. It is the practice they believe they have no choice but to implement in the wake of the House of Lords' decision on Equitable Life in July 2000.
The key to Equitable Life's practice, pre-Lords, was that the value of a policyholder's benefits would be the same, whether or not they exercised their guaranteed annuity opt-ion. The tweaking of the terminal bonus was simply a means to that end. In other words, the policy should hold the same value, no matter what you did with it. The essence of the House of Lords' objection to that practice was that it seemed to make the guaranteed annuity option worthless.
In adapting their practice to the Lords' decision, life insurers have taken that principle to its logical conclusion. If you get value from the guarantee by exercising it, then the converse applies. If you do not exercise it, you do not get its value.
In fact, many life insurers are going even further. You only get the value inherent in the guaranteed annuity option if you exercise it in the specific circumstances mentioned in the policy (quarterly in arrears, etc). So by simply choosing a different frequency of payment, you can diddle yourself out of a third of the value of your savings.
At which point do you evaluate the policy – before or after you have applied the guarantee? One actuary has pointed out to me that there are numerous references in the law to the relevant point being the “total value of the individual's acc-rued rights”, that is, the value if they choose to exercise their guarantee. So the value of the policy, in that case, should not be depleted simply by changing the annuity provider or the frequency of payment which would surely be an unfair term in any consumer contract and a matter for the OFT.
Life insurers' lawyers insist they are simply following the letter of the House of Lords decision which, privately, they regard as a bad decision. I do not know if that claim is true but whatever its causes, this practice hardly seems right.
Andrew Verity is personal finance correspondent at the BBC