Using an annuity to provide an income during retirement was once the go-to option for pensioners in defined contribution (DC) schemes in the UK. However, for the best part of two decades, Government pension policy and wider economic factors have meant the tide has shifted away from annuities towards other, more flexible pension options.
This started with pension simplification in 2006, which saw a colossal overhaul of the pension rules and brought in a single tax regime. The political capital available from being able to claim to have ended compulsory annuitisation has meant more recent Governments have tried to lay claim to this achievement. Whilst the precise point at which annuitisation ceased to be compulsory is the subject of debate, I’d argue that the 2006 reforms were the point that the requirement was removed. Instead of choosing an annuity, pension scheme members could leave their pensions in income drawdown. At age 75, this involved converting to a form of drawdown called alternatively-secured pension (ASP). ASP had minimum and maximum income limits and tax charges of up to 82% on death benefits, which meant, for some, annuitisation might be a more attractive option, but compulsion had disappeared.
In 2011, the rules changed again and it became possible to leave DC pension funds uncrystallised beyond age 75. This meant there was no longer compulsion to take benefits from a DC pension at all, let alone purchase an annuity. The death benefit options in DC schemes also became considerably more flexible, especially when compared to those available from DB schemes and annuities.
And then in 2015, the introduction of pension freedoms substantially increased the flexibility of options available in the defined contribution market. While a new form of flexible annuity was also introduced, it was overshadowed as savers were more attracted to the new drawdown and lump sum options. FCA statistics show that, of the 646,530 pension plans accessed for the first time in 2018/19, only 73,977 – or 11% – were used to purchase an annuity. Association of British Insurers (ABI) data shows annuity sales have declined by around 80% since pension freedoms were announced in 2014, and have remained around that level.
The 2015 pension freedoms supercharged the drawdown market. For the first time, people could withdraw as much of their pension as they wanted. Of course, the annuity market wasn’t the only part of the guaranteed pensions arena affected, with many choosing to transfer DB pensions following the introduction of the freedoms.
Challenges within the annuity market itself have been part of the reason it has fallen out of favour with savers. These include reducing gilt yields, increased mortality rates, reduction in morbidity rates, negative attention because so few savers shop around with alternative providers or for enhanced annuities, and reduced competition between providers.
Gilt yields are now well below 1%, having been as high as 5% around a decade ago. The ongoing decline in these rates, both before and since the financial crisis, is one of the key drivers for the drop in annuity rates. Insurers are also having to contend with life expectancy hitting record levels.
As annuity rates have dropped, the perception by some savers that they offer poor value has risen. A reduction in the number of insurers in the market means less competition, which in turn has an impact on the perception of value. This cycle ultimately results in more retirees choosing alternative pension options.
The FCA clearly still values the consumer protection inherent in annuities. It has attempted to fix at least some of the issues with the market in its Retirement Outcomes Review, making improvements in the information provided by insurers regarding alternative or enhanced annuity products. It is arguably also making drawdown less attractive by making the process of customers entering drawdown more complex. This interventionist approach in the drawdown market has already seen the introduction of risk questions and warnings, and will soon require providers to offer a default investment pathway to non-advised customers.
Reduced competition in the annuity market is likely to lead to poorer outcomes for individuals seeking security in retirement. They are essentially tasked with choosing between an annuity product they perceive to offer poor value and a drawdown product which is more complex.
All of this makes it even more important for individuals to take regulated advice. While Government-backed guidance services like Pension Wise and the Money and Pensions Service are a step in the right direction for those for whom advice isn’t an option, the importance of good quality advice cannot be underestimated.
This article was previously published by Professional Paraplanner
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