The annuity puzzle – what price the guarantee?
Post pension freedoms the sale of annuities, perhaps understandably, seems to have fallen off something of a cliff.
The statistics show that income drawdown is now the first choice retirement option, but they also suggest that investment risk is not what some people want.
So when I see headlines about income drawdown becoming the retirement default option, as opposed to annuities, it makes me a little bit concerned that we are confusing products and client needs.
Let’s not forget that annuities are insurance contracts that pay out a sum assured – okay, as gilt yields fall the cost of buying the sum assured (the level of income) goes up but as an insurance product you have chosen the level of sum assured that you require.
The principle of an annuity is simple – the premium is paid to an insurance company and in return they send out a monthly income for the rest of your life and possibly longer to any beneficiaries included in the contract.
So you have purchased longevity insurance – you cannot outlive your money. Add in a bit of ‘mortality credit’ (where insurance companies use the unpaid assets of policyholders who die at younger ages to pay out to those who live longer) and the payout rate should be competitive in relation to the underlying actuarial assumptions.
In the UK we have seen great upheaval in the annuity markets and a number of insurance companies have pulled out. The question, therefore, as to whether we have the ‘best’ market that we could have is a subject for further consideration.
In the US, research has shown that the optimum product for retirement is the annuity but in spite of this there are always barriers to purchase – the so-called ‘annuity puzzle’.
A lot of these barriers can perhaps be explained by behavioural science, short-term liquidity, underestimation of life expectancy, fear of losing control of the money etc.
So what is more important; the level of sum assured (income) or the fact that it is guaranteed? A falling rate (income) can be important but what would be the lowest price that would make the guarantee less important than the sum assured?
Clichéd though it may be, that famous financial planner Charles Dickens had a view on this:
"Annual income twenty pounds, annual expenditure nineteen nineteen and six, result happiness. Annual income twenty pounds, annual expenditure twenty pounds ought and six, result misery."
In 2011, the then FSA published their final guidance on assessing suitability with the title:
“Assessing suitability – establishing the risk a customer is willing and able to take and making a suitable investment decision.”
It was these two words “willing” and “able” that interested me (perhaps more the latter rather than the former).
Lots of people will say that they are willing to accept investment risk but do they really understand what investment risk is and how it can affect their income?
In the retirement equation, longevity risk is perhaps the biggest unknown and one that can do the most danger to what might be a limited amount of money.
According to new research a child born today has more than a 50% chance of living until age 105! Longevity can be a great thing but not having enough income to last that period could be a serious issue.
For many people a combination of annuity and drawdown could be the answer - with an annuity to fix a required minimum level of income and the excess as drawdown with that element of investment risk.
We are still in the early stages of experience of the pension freedoms legislation but recent Citizens Advice Bureau research showed some concerning results as to what people are doing with their encashments.
My prediction is that over the next few years there will be some high profile stories of poor retirement outcomes that could well mean a renewed call for a minimum income to be secured. We could well then reiterate my question above – what price the guarantee?