Flexible lifetime annuities and money-back guarantees are the way forward for the pensions industry because they provide for the fact that people are living longer on average but an early death cannot be ruled out
Annuities have now become big news and it has been a long time coming. The world has moved on and people are living longer, staying active and spending money like never before.
New products are needed to meet these new needs. 2001 saw the introduction of the new generation flexible lifetime annuities and 2002 may well prove to be the year of another major breakthrough ' the money-back guarantee.
Life can be divided into three ages. The age of learning (up to about age 30), the age of work (up to about age 60) followed by the third age. But how long will the third age last?
If we knew the answer to that question, then retirement planning would be easy. We would decide how much we were going to leave for the kids and spend the rest with the final cheque going to the undertaker. Unfortunately, life is not that simple and the actuaries tell us that there is a wide range of possible ages at which we might die.
The average life expectancy for a man aged 60 now is estimated to be 84 but its also estimated that 27% will die before age 78 and 25% will live beyond age 90. That tells me that just under 50% of us are going to die in the 12 years between 78 and 90. But when exactly?
Of course, we also don't know whether our homes will burn down or whether our cars will be stolen. But we can get over that worry by insuring the risks. So why not do the same with our retirement income?
Insure against the risk of running out of income. By investing our retirement savings in a pension annuity we can guarantee ourselves an income for life, however long that may be.
Not only will most people enjoy three ages during their lives but they will probably accumulate three pots of personal wealth too. These are pension savings, non-pension savings (such as Isas and deposit accounts) and domestic property. All three must be taken into account when planning for retirement.
By optimising the lifetime income generated from pension savings, the other two pots of wealth (non-pension savings and domestic property) can be better protected for eventual inheritance by the children.
Regardless of the amounts of wealth accumulated in the three pots, a money back guarantee will have universal appeal to all that buy an annuity.
It will be a death benefit option that is chosen at retirement and will guarantee that live or die, you will get your annuity purchase money back.
In the event of death, the difference between the original purchase amount and the total of gross payments already received would be returned to the estate as a taxable lump sum. This would require the Inland Revenue to extend the principle of commutation to all pension annuities and to stipulate how the lump sum would be taxed.
This change would benefit the whole spectrum of annuity purchasers and address one of the main fears about annuity purchase ' that if someone dies soon after buying an annuity, the provider will pocket their hard earned savings. Like all worthwhile guarantees, the money back guarantee will not be free, but neither is it prohibitively expensive. In fact it is estimated that it would cost on average about 2% more than the current 10-year continuing income payment guarantee.
Although the availability of a money back guarantee will improve the image of annuities in consumers' eyes it is the fact that annuities guarantee an income for life that is their greatest benefit. Annuities operate on a pooled insurance basis where the remaining funds of those who die before their life expectancy are used to pay the incomes of those who live beyond the average.
Of course, few die in their 50s and 60s, so this cross-subsidy (sometimes called a lifetime bonus) is small in the early years. But by the time annuitants are into their 70s and 80s, the amounts involved become bigger and bigger as each year goes by (See Chart 1).
The left hand side of chart one will be familiar to some as the mortality drag curve up to the age of 75 in the context of income drawdown. The mortality cross-subsidy starts low but builds exponentially.
In drawdown, it becomes an increasing burden with age and has been labelled a drag. But flexible lifetime annuities offer the opportunity of turning this mortality drag into a survivor or lifetime bonus. As you will see, this bonus becomes particularly valuable with age and is about 5% at age 80 and over 10% in late 80s.
Another factor that changes each year in retirement is attitude to risk. In particular, most people look to reduce their investment risk as they grow older. This suggests that given the freedom to do so most retirees with sufficient funds would probably wish to be in equities during the early years of retirement and gradually move in to less volatile assets as they grow into old age. One of the consequences of this phased investment strategy that one would expect is a reduction in investment returns. Currently equities might be expected to outperform bonds by about 2% pa.
But increasing mortality cross-subsidy can compensate for decreasing investment returns if a holistic approach is taken to retirement planning (see Chart 2). It is no longer sensible to adopt an either/or approach. It should not be seen as an exclusive choice of drawdown or annuity, one or the other.
It could be far more advantageous to combine both in order to maximise the benefit to the customer. It is now possible to start off in personal pension and move gradually into drawdown (perhaps to maximise potential death benefits in their 60s) and then into flexible lifetime annuity (to take full advantage of the mortality cross-subsidy as it quickly increases in their 70s).
Chart two shows how a retirement account might reduce the fund at risk on death in the early years (through drawdown), but access the significant benefits of longevity insurance at older ages (though flexible lifetime annuity).
It shows how a client might actively manage investments in a drawdown/flexible lifetime annuity combination over the whole of retirement and what might happen as the client moves to less volatile assets as he or she becomes more risk averse with age. Typically, returns would be expected to reduce. Here equities returns of 7% pa and bond yields of 5% pa are assumed.
Regulation requires full annuitisation by 75, but is this such a bad thing? Significant additional returns available by this stage from lifetime bonuses can reduce reliance on investment returns. The quid pro quo is that death benefits would cease by age 85 under current annuity legislation.
Having worked hard to accumulate a retirement fund, a focus on death benefits at that stage is understandable. By the age of 75, the attitude of many clients will have changed as they realise they have already had value from their fund. After all, they might still need a further 10 to 15 years income from the remaining fund. By this stage of life, sustainability of income will have become much more important than death benefits. So, what we have here is a wealth management strategy that can be tailored to an individual client's needs.
For some, annuitisation before 75 may be appropriate or perhaps progressive annuitisation in the run up to 75. Although regulation may require a change from drawdown or personal pension to annuity by 75, this need not prohibit an actively managed investment strategy throughout the client's life.
This approach takes advantage of each of the pension disciplines (PP/drawdown/annuity) without destroying the preferred investment strategy each time the client moves from one to the other.
One welcome development from this more innovative and inclusive approach to retirement income provision is the realisation that drawdown and annuities work best in combination ' just like a good team should.
Annuity is insurance against the risk of running out of income.
Money back guarantee as an annuity is comparatively cheap.
Look at non-pension assets and investments as part of overall retirement planning.