Annuities put to the test drive

Andy Miller, product technical manager at Prudential, uncovers the myths surrounding annuities as an investment model.

I have recently replaced my car. My previous car was a fairly uninteresting estate model from a leading manufacturer, which I bought on the basis of reviews by people who know rather more about cars than I do.

As I have been very pleased with it, I replaced it with a new model of the same, fairly ordinary car, which suits me just fine. The updated model has a sportier look and a few more toys and gadgets (all of which my wife tells me are unnecessary), but it is basically the same car. There are plenty of similar models from other manufacturers, many of which seem to be every bit as good as the one I opted for. I looked at several. I even test drove a couple. In the end, I decided to stick with what I know.

If FSA rules applied to the car industry, when I went back to the dealer to change my car he would have to tell me that there were lots of other cars deals available elsewhere. That is what happens when a client with a pension nears retirement age: they don’t have to buy an annuity with the same provider. In fact, the pension provider has to make them aware that there are other deals on the market – otherwise known as the Open Market Option (OMO).

Awareness of the OMO

However, there is a common belief that providers send out information on the OMO, either accidentally or otherwise, that is too complex, or even misleading. Some detractors have argued that, as a result, annuitants are not aware they have an OMO, or if they are, how to exercise it.

In fact, some say communication is so bad that those who qualify for enhancements do not get them, and likewise those who should take joint life annuities, rather than single life, end up with the wrong option. The ABI recently carried out a survey of 750 ­annuitants on exactly this topic (ABI Research Paper number 23, July 2010). Let’s look at some of these criticisms.

The vast majority of annuitants are aware of the OMO (96 per cent). Of them, more than two-thirds actually take the time to shop around, either independently or via an adviser. Of those who do not, most say it is because they are happy with and confident in their existing provider, or because their pension pot is so small that the actual difference in their income is minimal. Clearly, though, the message is coming through from providers that the OMO is there – and most clients are taking heed.

Enhancements need boost

Of those in the survey who might potentially qualify for an enhancement, a fairly small minority of annuitants actually took advantage of this, but most are aware enhancements are available. So why do more not use them?

The picture is not quite as clear as it would seem. Different providers offer different bases for enhancements: different illnesses for example, or enhancements for smokers. Providers who offer enhancements on a greater number of conditions do not necessarily offer the best terms, even when compared with a provider that does not offer an enhancement. So, for example, ABC Life may offer an enhancement to Mr Smith because he is a smoker. XYZ Life does not offer him an enhancement, but its rates are more competitive regardless, so Mr Smith opts for this one. So just because you qualify for an enhancement does not mean that you necessarily take it up.

Joint and single life

Again, most of those surveyed were aware of joint life options. About 39 per cent overall went on to buy this type of annuity.

Obviously, a joint life annuity is not suitable for those who are single. Nor is it likely to be suitable for most married women who have their own pension provision, since it is statistically likely that their partners will die before them. Taking into account the number of male annuitants and the proportion of these who are married (deducting the number whose wives are likely to have an annuity in their own right) the number who buy a joint life annuity should be about 38% to 39%, which is remarkably similar to the number in the survey. So it is reasonable to conclude that the right proportion of annuitants are taking a joint life annuity.

Annuities and advice

In almost every case, those who used an adviser found it beneficial. Use of a financial adviser was clearly the best source of information, but less than half actually used one. Why was this? Many of the pension funds were small and, as a result, some respondents felt there was little point in paying for advice. Others felt sufficiently competent to make decisions independently. But there is no doubt that many who would have benefited from advice did not seek it.

Retirement income advice is one area which is likely to evolve rapidly, particularly in view of some of the legislative changes the coalition government is making. State benefits will provide little for those retiring now, and less for those retiring in the future.

Meanwhile, inflation is likely to remain relatively high, for the immediately foreseeable future at least, and people are living longer. Drawdown is likely to remain suitable only for a minority, due to insufficient fund size, investment risk and loss of mortality cross-subsidy. Perhaps asset-backed annuities, such as with-profits annuities, should be a greater consideration, providing many of the benefits of an annuity, while offering the potential for investment growth to counteract inflation.

Confidence and trust

Of those approaching retirement, most are aware of their options. Many evaluate these options at length, either with or without an adviser, and more than 80 per cent are satisfied with the information they receive from their provider. The result is that 92 per cent, a remarkable majority, say they are confident they have purchased the right annuity.

Why then do some consider their options but opt not to change providers? Those approaching retirement should always check they are being offered a competitive rate; that is clearly logical. But it is also logical to place a value on such factors as security, service and reliability. This is especially true when buying a very long-term product such as an annuity, which people will depend upon to provide an income for the rest of their lives.

So, someone approaching retirement may ‘test drive’ another provider to check their rates. But if they are happy that their pension provider is offering broadly the best rates on the market, and they are pleased with the service they have had, the same principles apply as when I bought my car. I was happy with my last car. I was perfectly content with its performance. It may not have been the fastest on the road (perhaps due to the driver), but it never broke down. It was comfortable and had all the features I was looking for. The dealer had a good reputation, and was consistently polite and prompt. So I chose to buy from them again.

Perhaps I have not chosen the best car on the market, but my decision was perfectly rational, and I have purchased something rather less tangible: namely, confidence and trust.

Andy Miller, product technical manager at Prudential