Why advisers should consider third-way products

An alternative to conventional annuities and unsecured pensions has emerged as a popular retirement choice, writes Mike Morrison, head of pensions development at AXA Wealth

Is an annuity an investment, or is it an insurance product, insuring you against living too long? If you regard it as the latter, the important bit is that it will pay out for the whole of an individual’s life, however long it might be.

On the other hand, an annuity as an investment is unlikely to be attractive, because annuity rates are generally based on gilts rates, and there has to be sufficient security for the annuity to last as long as it has to. For most people with relatively small pension funds, annuity purchase will be the only option, because they need security and cannot afford to take any investment risk.

However, an increasing number of people are likely to seek a more flexible approach, and if they have a large enough fund it might be possible to defer annuity purchase and use income drawdown in the interim.

So, at what point might annuitisation become attractive? There will be a number of factors that are likely to inform any decision to buy an annuity, including attitude to investment risk, flexibility on the requirement for income and the possible benefits available on death.

Mere mortality cross-subsidy

Another factor to consider is the ‘mortality cross-subsidy’ mortality drag. When annuity providers set their annuity rates, they know that some annuitants will die before their average life expectancy and some will live beyond it. In such circumstances, the unused funds of those who die earlier than expected help to pay the annuities of those who live on. This process is called mortality cross-subsidy. It means that if you do not use an annuity to provide pension income and try to use a portfolio of investments, there will be no benefit from mortality cross-subsidy. To compensate for this, the chosen investments will need to grow by an extra amount (the mortality drag).

As longevity increases, there is unlikely to be any real mortality cross-subsidy until nearer to age 70. This is another reason why annuity purchase could well be deferred: Why buy early if there is no real investment advantage and you might lock yourself into an inflexible structure with no upside? This could be a real enticement to turn to income drawdown, even for a short period of time. But are investors aware of the risk?

For individuals with relatively small funds, say, less than £200,000, and no significant annuity, deferral can be something of a quandary: maintaining flexibility but also maintaining purchasing power.

Let’s take a typical client who could buy an annuity of £15,000, which is pretty much what he needs, but he feels that he wants some flexibility in the short term and does not want to commit to buying an annuity yet, so suggests deferring for say five to six years. His worst-case scenario would be to take too much investment risk, so that when he comes to buy an annuity, the amount he can now buy is less than £15,000. In the ideal world his fund will be much higher and the amount that he can buy will be much higher. Unfortunately, this would probably mean too much investment risk.

In reality, the optimum solution is probably for the client to have taken his required income and the real value of his fund maintained, with the result that the annuity he can purchase is higher just on the basis of his being a number of years older. In effect, he has maintained his annuity purchasing power and enjoyed a period of flexibility if he had died. This will not always be easy to do, and for many clients, being told that their required level of income will mean too much investment risk and that they should buy an annuity, is not what they want to hear.

So, here is the conundrum. Conventional annuity purchase provides a guaranteed income for life, but buying an annuity means giving up access to potential investment growth. Once bought, the annuity cannot be altered, and there is no remaining fund on death (although some spouse’s benefits or a guarantee period could be purchased in return for a lower starting income).

Income drawdown offers investment growth potential, flexibility and a return of the accumulated fund on death. However, the fund value is exposed to investment risk and is affected by the prescribed income limits. Therefore, if the fund value halves, effectively so does the amount of income the individual will be allowed to take. The individual is also exposed to long­evity risk and may have to reduce their income if they live longer than expected.

Third-way products

It is this polarisation that has seen the search for something inbetween: a third way. Over the past few years, we have seen the introduction of so-called third-way products, offering exposure to investment growth and equity markets but with the ability to build in guarantees, perhaps on the level of income that can be taken or in the underlying capital value.

These products have been referred to as variable annuities or conversely drawdown with a downside guarantee. In the US, variable annuities have been popular for a number of years, and it is from there we can learn lessons about the development of such products.

So far, products launched in the UK have been criticised as being too costly or too complicated, but gradually they are starting to be used as an alternative to conventional annuity or unsecured pension. It is likely that the future will be good for the third way.