Retirement Puzzle - Annuity Switching – Does Steve Webb’s idea have legs?

In a recent interview for the Daily Telegraph, Pensions Minister Steve Webb said that buying an annuity was a "lottery" that could affect pensioners' retirement income by 15% or 20%, in some cases. Drawing comparisons with mortgages where consumers can switch products and providers, the Minister went on to challenge why consumers shouldn’t also be able to change annuity providers and products a few years later if they could receive a bigger pension. In this month’s article I take a closer look at this challenge by Steve Webb and highlight some of the issues.

 By Tim Gosden, Head of Annuities at Legal & General

 How flexible is the current system?

 The UK system of retirement income provision is the most advanced in Europe and probably leads the world. Consumers have the freedom to shop around the market for the best income solution and obtain financial advice if they wish. There are a multitude of diverse product options including conventional guaranteed annuities, both standard and enhanced, investment linked annuities, flexible annuities, fixed term annuities, variable annuities and income drawdown.

 Is switching viable for the mass market?

 The conventional annuity, standard and enhanced, is the core product in the marketplace and according to most recent industry statistics accounts for roughly 90% of all retirement income contracts sold. This is simply because most consumers desire a guaranteed income stream. Conventional annuities are often criticised for being inflexible because once taken out they cannot be altered to take account of changing personal circumstances and/or market conditions.

 From an annuity provider perspective, to facilitate a switching option as suggested by the minister would be challenging. To offer the more competitive rates available today, most providers now invest in illiquid investment opportunities, such as infrastructure projects, that cannot be readily traded, but which offer better long-term returns. An option to switch out of annuity contract would require providers to invest in shorter term, lower yielding assets with a corresponding loss of liquidity premium under Solvency II that would increase the requirement for regulatory capital. And on top of that, there would be additional administrative expenses. We estimate that, taking into account these factors, the overall impact of offering a switching option could be a 25% reduction in a customer’s starting income.

 When purchasing an annuity the most important considerations for consumers are health issues, which could lead to improved terms, the provision of death benefits for a spouse or partner and shopping around for the best deal. Many consumers preference is to maximize income and currently very few include any form of inflation proofing to their annuity because of the cost. Given the average UK pension pot is currently around £32,000, the reality for most consumers is that their private pension is often just a top up to the State scheme and so the flexibility to be able to change their annuity may come at a cost that most would simply not consider. Also, without the services of an adviser to explain the option, it is likely many wouldn’t switch or know when was best to switch.

 Is there a demand for the existing more flexible solutions?

 Fixed Term annuity products were specifically introduced to counter the flexibility criticisms of conventional annuities. With these products a short-term annuity is purchased with some of the fund, while a guaranteed maturity value at the end of the term is provided with the rest of the fund. So at a future date a new retirement income product can be purchased, maybe on better terms if a change in circumstances, such as a deterioration in health, has occurred. While these products are innovative and to an extent address the flexibility criticism, they currently account for less than 1% of retirement income contracts sold. This is mainly because they can only be accessed through financial advisers, who will usually recommend them to customers with larger pension funds.

 Does the current system cater for everyone?

 Flexibility and choice already exists in the UK annuity and income drawdown markets. There are already alternatives to the conventional annuity for those that require flexibility and who are willing to take more risk. The question is how consumers can access these products particularly if they do not wish to use the services of a financial adviser. The conventional annuity product fulfils a hugely important need and so perhaps the solution is more about improving accessibility to these diverse alternatives, but only to those for who they are suitable.

 What’s the best thing consumers can do?

 Get advice and shop around. There are competitive annuity providers that offer a good deal and value for money.

 Talk to someone!

 Not everyone will opt for the services of an adviser but we believe everyone deserves a conversation about their annuity with someone knowledgeable. Annuity purchase is perceived as a complex decision and many consumers find they are confused and often take the easiest route, which may not always be the best for them.

 The industry needs to find a way of ensuring that every consumer has that conversation, whether that is with their provider or with an adviser or an intermediary.

 Is Steve Webb right to challenge the annuity industry?

 Yes absolutely, we should be constantly looking at ways of improving annuities and making them more flexible within the bounds of the regulations. At Legal & General we are reviewing our annuity proposition to try and improve flexibility but we are also very mindful of and have considerable insight into consumer behavior and their priorities when it comes to choosing their retirement income. We know maximising income is a key priority for many and so the benefit of any added flexibility we include has to be at a price that our customers are willing to pay.

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