Adapting to change

Helen Morrissey discusses the annuity market with a panel of experts

- Philip Brown is head of retirement & care product development at Partnership

Philip has been working in the life and pensions industry for over twenty years. During his career he has been head of customer services and technical administrator at Teachers Provident Society and a senior policy adviser at the Financial Services Authority. In this role at the FSA, Philip was instrumental in the development and launch of the FSA Comparative Tables.

About Partnership

Partnership is one of the UK's leading providers of financial products for people who don't fit the 'standard' mould, either because they have a health condition or they smoke.

For over a decade we've been providing people with products where the benefits are often much higher than those from standard providers.

As well as enhanced annuities, Partnership offers market leading long term care products and a fully underwritten equity release product. In addition, we've applied our unique knowledge to be able to offer a range of protection products to people who have been declined elsewhere.

- Darren Dicks is head of annuity proposition at Norwich Union

Darren has worked in the financial services industry for eight years and has held a number of roles including head of planning and head of protection marketing. Prior to joining Norwich Union Life, Darren was a management consultant with PWC where he specialised in cost reduction and efficiency, advising many different companies within the manufacturing industry.

About Norwich Union

Norwich Union is the largest insurance services provider in the UK. It is a leading provider of life, pensions and investment products and one of the largest financial adviser providers. Financial advisers provide over 70% of the company's long-term savings business in the UK.

- Bernard Footitt is technical support manager (pensions) at Canada Life

Bernard joined financial services in February 1986 and has since developed a high level of technical expertise in pensions.

Latterly, Bernard provided assistance on a consultancy basis with pensions development for National Australia Bank working with the bank's IFAs to develop their pension business book in the run up to pensions simplification.

About Canada Life

Canada Life was founded in 1847. With assets under administration in excess of £193 billion as of year-end 2007, Canada Life now has an even stronger platform for continued growth as a world-class financial services provider.

In the UK alone Canada Life manages over £10 billion of pension assets.

- Athole Smith is head of product management at Prudential

Athole has worked for Prudential for over 10 years. He has worked in different areas of the business including customer services and product management and is currently responsible for the design and development of retirement income products including with-profit annuities and drawdown. He is also responsible for Prudential's annuity pricing. Athole is a qualified actuary with over 20 years experience in financial services.

About Prudential

Prudential is a leading life and pensions provider to over seven million customers in the UK. It provides a range of products including annuities, corporate and individual pensions, with-profits and unit linked bonds, savings and investments, lifetime mortgages, healthcare and protection.

We have seen increased movement towards enhanced annuities and postcode related annuities over the past year - what do you think this is indicative of? Do you think for instance it's a movement towards a more personalised service where people get an annuity more tailored to their specific circumstances?

Brown: Looking into the future it is possible to see a world where a 'standard' annuity is no longer the norm, and an individually profiled annuity is commonplace. The ongoing developments in the enhanced and impaired annuity market, the development of smoker annuities and the introduction of postcode annuities, shows that providers are increasingly looking to tailor annuities to individuals' life expectancies. Clearly any move away from a standard will mean that there will be winners and losers - which, in our view, means that it is even more important that consumers shop around as annuity providers take different views on longevity risk.

Dicks: First and foremost it is about being fair to customers. Norwich Union (NU) has adopted postcode pricing to all customers (internal and external, large or small fund size) because it is a principle of fairness. It has long been recognised that wealthier people on average live longer than less affluent people. Therefore the poor have been subsidising the rich. The annuity market has only offered rates based on gender and age, when there are so many other factors which influence a person's mortality. The move to enhanced and pricing factors is a feature of providers ensuring we offer a rate which reflects that customer's circumstances.

Footitt: This move seems to indicate a number of things. Firstly, annuity providers now have more data and underwriting engines to refine their annuity rates based on these factors. In addition, there is a recognition that consumers are not prepared to accept a blanket annuity rate based only on one set of average mortality data. There is also the rapidly increasing pool of maturing pension pots making this an attractive market sector for providers. Finally, I do think that we are moving towards an annuity market that has the data and provider technology to provide a personalised annuity rate for all applicants quickly and with great efficiency.

Smith: This change is taking place for various reasons. Firstly, advisers and customers are now more aware of their options and so are actively seeking out the product which best meets their retirement income needs. Secondly, there is more competition in the annuities market and providers are seeking to ensure that the business they write reflects the risks they are taking on while offering value to consumers. Thirdly, technology is enabling providers to gather and use more rating factors when pricing annuities.

How capable are current underwriting systems of delivering this level of detail? Is further development needed?

Brown: Fully underwritten annuities do necessitate skilled underwriters to continually review experience and adapt underwriting practice. In my view there are only a limited number of underwriters who specialise in annuity underwriting, which is clearly different to life underwriting.

Dicks: There are many underwriting systems and alternatives to accommodate pricing factors. The life insurance market has been developing this expertise for many years. Further development is required but it will not prevent progress in this field.

Footitt: In recent times we have seen the use of technology enabling annuity providers to produce instant, guaranteed quotes even for severe conditions but my guess is that the current underwriting systems need further development to be even more effective. However, the critical factor, as I understand it, is the ability or willingness of consumers and their advisers to provide more details of medical conditions and lifestyle factors, such as, obesity, smoking and alcohol consumption.

Smith: Underwriting systems and processes will continue to evolve. Historically, underwriting was done only on seriously impaired lives by expert underwriters. Now, providers use automated systems which can be used to provide terms reflecting ill-health and lifestyle factors. However, we would always expect some degree of human underwriting. There will be exceptions where the only way to offer the best possible rate will be to pass the case to an underwriter.

What effect do you think the FSA's thematic review of the open market option will have on the annuity market? Do you think providers are heeding the FSA's advice?

Brown: The FSA has highlighted issues such as choice of annuity provider but an annuity has a profound impact on so many peoples' lives. We believe that the only way to ensure that individuals have the best chance of maximising their retirement income is to make the OMO the default option for all pension scheme members reaching retirement.

Dicks: I would prefer to talk on behalf of NU where we have been a constant advocate of people seeking advice and making the right choice at retirement. I believe the review will have an effect on the number of people exercising the OMO and will continue the rising trend. However a different solution will need to be developed for small pension funds which are uneconomical for advisers to perform fully regulated advice on. It is an industry issue, the customer was sold the pension and he needs to be guided into making the choice which reflects his circumstances.

Footitt: First of all, I think that the FSA's thematic work on the open market option (OMO) confirmed what the industry already knew collectively about how the OMO was working. It also confirmed that over 60% of the industry's OMO material either met or exceeded the minimum standard that the FSA required. The more interesting findings on 'alleged delays' in transferring OMO funds to a different provider is perhaps more revealing. Following a random selection of cases for review, the FSA found that just over 60% were delayed with about 42% (of those cases with delays) labelled as unacceptable delays.

Although there was some analysis of the causes for delays - mainly bureaucratic and simple inefficiency on the part of transferring firms - resulting in individual feedback to the firms concerned, it seems for the moment that the good guys are still the good guys and the bad guys will take a while to become good guys.

Although life offices must accept responsibility for delays we must also remember that the hold ups are often caused by the need to complete forms prescribed by HMRC, namely the CA form for protected rights and the lifetime allowance declaration. The latter is only relevant to less than 1% of customers that have large funds but causes a great deal of confusion to the majority. These forms are often completed incorrectly (if at all) and with the threat of a financial penalty from HMRC hanging over the ceding scheme if the OMO is paid incorrectly, most life offices will ensure this is fully completed before the OMO is paid, even for a client that only has a small pension pot. Hopefully the ABI work with HMRC to simplify these forms and processes will be fruitful in helping to overcome these barriers.

Smith: The FSA report will lead to higher standards of communication and education across the industry which should result in all customers gaining a better understanding of their options at retirement. Given that research has shown that less than a fifth of people seek financial advice leading up to retirement, this communication also needs to highlight the benefit of financial advice, which in turn should result in greater use of the OMO. Other aspects of the end-to-end OMO process also need to be improved such as the time taken to set up retirement income plans and a better understanding that seeking the best rate is not always the best solution. Customers need to understand their long term income needs and risk attitude and then find the most suitable product. All of this leads to greater need for financial advice and a better outcome for customers.

How can we improve choice at the lower end of the market? For instance people with small pension pots only have limited choice when it comes to exercising their open market option?

Brown: The area of greater concern for me is those with pension pots of less than £5,000 who have very limited access to any advice whatsoever.

Dicks: Unfortunately many people are still not aware of the triviality rules and coupled with many customers not taking advice it leads to a lot of small fund annuities. This is not economical for the industry, customers can also amalgamate pension funds which will often receive a better rate than if the pension funds are annuitised separately.

Footitt: The lower end of the market really is a difficult area with access to financial advice being particularly troublesome and that has an impact on consumers getting the best annuity for their money.

As the market is so competitive with every provider wanting to squeeze the best rate possible in exchange for the individual pension pot on offer, increasing commission as a percentage of the pension fund to reflect a decent payment for the work involved is still only available from one or two companies. Equally, most people with a small pension pot would be reluctant if not unable to pay a fee to reflect the work undertaken by an adviser to source and arrange the best annuity available, so we seem to be in a double-bind on this front.

Other complicating factors not allowing us to really get down to the extent of the difficulty in obtaining the best rate for a pot of say £10,000 or less, include the fact that having your pension with a top-of-the-range annuity provider removes the need for the OMO exercise straightaway; secondly, a number of the best providers have a minimum purchase price of £10,000 or more.

Smith: Providers can offer flexible commission structures to ensure it is worthwhile for an IFA to provide advice on small cases.

Are people effectively rediscovering the benefits of annuities in light of recent volatile stockmarkets?

Brown: Market volatility may have a couple of effects on the annuity market. Firstly, uncertainty may lead those who can afford to delay annuity purchase to consider doing so. However, the counter balance that needs to be considered is a downward trend in interest rates may mean their delay could conceivably result in a lower annuity rate. Secondly, volatility may make investment-based annuities, such as with-profits annuities, less attractive.

Dicks: People are reassessing their attitude to risk at the moment and with volatile stock and money markets, customers are realising that annuities offer good value at the moment with no risk

Footitt: Let's hope so, because a number of retirees have become seduced with 'retaining investment control' above all else to go with drawdown when their pension pot together with other financial and personal circumstances perhaps may not have warranted it. Financial advisers often found themselves in an invidious position when some clients insisted that they did not want to annuitise despite the evidence that annuitisation was the most suitable option for retirement income.

Certainly the current market volatility has reawakened people's interest in annuities together with a new awareness of the 'value for money' that annuities represent together with the escape from the vagaries of the market. There are several hybrid annuities that answer some of the disadvantages of a conventional lifetime annuity, particularly those associated with improved longevity working against future changes in health and personal circumstances that would render a conventional lifetime annuity (LTA), purchased earlier, now inappropriate.

Smith: Annuities are the only products to provide full protection against longevity and investment risk. However, recently many customers have seen their pre-retirement funds fall substantially. This means that, even though the certainty annuities provide is appealing, customers do not wish to purchase while their funds are so low. One option being considered is to invest in asset-backed annuities. Another option is to avoid realising pension pots and to defer buying an annuity in the hope that pension funds will pick up. This carries obvious risks - funds could drop further or annuity rates could worsen.

There has been much talk of variable annuities since they entered the UK marketplace two years ago. What can they offer that annuities can't? Could with-profits annuities be deployed to similar effect but at cheaper cost?

Brown: Variable annuities have a place in the annuity market, as do guaranteed investment products in the investment market. The main issue, in my view, is the cost of the guarantee and therefore, the required investment return needed to actually achieve higher returns. All of which needs explaining to customers. Investment based annuity and income drawdown have been around for quite a while now. The main thing that needs to be established is what the customer actually wants and what available options are based on their fund size and risk appetite.

Dicks: Variable annuities offer flexibility of investment choice and guarantees which come at a cost. Annuities offer guaranteed income at a fixed price at point of sale. A with-profit annuity offers pooled investment in a with-profit fund which is smoothed over time with regular payments of income.

Footitt: Firstly, a variable annuity in its income drawdown form is neither an annuity nor is it variable. These products are more correctly guaranteed unit-linked income withdrawal plans, even though the majority of guarantee riders available are at best partial.

They do offer partial guarantees from a menu that applies to minimum income/withdrawal, minimum death, and/or minimum accumulation benefits. Well annuities offer an income that is guaranteed for life, often with a term-certain guarantee regardless of whether the main annuitant lives or dies during the term. They can offer guaranteed return of residual purchase price on death before the age of 75, and have no need of guaranteed accumulation levels unless the lifetime annuity is investment-linked.

As regards cost, investment-linked annuities as a sub-group of lifetime annuities do not necessarily have to be on a with-profits basis to be less expensive than the guaranteed unit-linked income withdrawal plans. There are a number of unit-linked hybrid lifetime annuities available, as well as at least one SIPP investment-linked product.

Smith: Essentially, variable annuities are products offering investment upside with some form of capital or income guarantee. As such, with-profit annuities fit perfectly into this space as they offer customers longevity insurance with investment upside. In particular, being true annuities, they offer the benefit of mortality bonuses. On top of this, the charges are lower than most variable annuity products available.

One common criticism levelled at annuities is that they are inflexible and you are effectively compelled to purchase one by the age of 75. How likely do you think it is that the age 75 rule will be amended or abolished in the next few years? Why do you think that it hasn't already been amended in line with increasing longevity assumptions?

Brown: Less than 1.4% of people buy annuities at age 75 or older. So, waiting for changes in the age 75 rule only assists a very limited number of people. I'm not sure that anyone with an average fund size gains anything from a change such as this.

Dicks: The government were keen to have an age limit to force annuitisation to ensure that the older generation have secured a regular income in retirement. It is mainly the wealthy who postpone annuitisation and if the government were to abolish the age limit altogether it could be used as a wealth transfer mechanism to avoid inheritance tax. It is unlikely that the government will abolish the age limit, however they may impose minimum limits of annuities at age 75.

Footitt: Well, here's a nice multiple choice question if ever I saw one! Annuities inflexible? I think not, as most people think only of pension annuities in their easily recognisable conventional form, there is quite a wide range of lifetime annuities that extends to enhanced, postcoded, etc., and impaired life rates. Add to that investment-linked versions, flexible and open annuities, and I think that diminishes the 'inflexible' tag.

Those who have got themselves into the bind that annuitisation by age 75 is compulsory now talk of "effective compulsion". My answer is that compulsion or non-compulsion are both absolute not relative positions. However unattractive the alternative to annuitisation at age 75 is, there is now no compulsion to annuitise at any age, therefore it follows that there is no need to amend legislation.

Smith: It is logical that age 75 should be increased though we would expect it to happen gradually in line with changes to the minimum age for taking a pension and changes to state pension age. There are some important questions which need to be addressed though, such as should you be able to make contributions to that later date. Any change should be part of a wider review of the taxation issues. Of course there is no such thing as compulsory annuitisation at age 75 (although you cannot take tax free cash after 75) and, in practice, only a tiny proportion of the population are affected by the rules around ASP.

How do you see the marketplace for fixed term annuities developing? Why are people purchasing them? Is it due to health concerns, possible future movements in the age 75 rule for instance?

Brown: As stated earlier less than 1.4% of people buy annuities at age 75 or older. So, waiting for changes in the age 75 rule only assists a very limited number of people. Short term annuities are much more beneficial for people concerned that their health may deteriorate or who already have conditions that might get worse. In these scenarios there is a clear advantage in people making use of short term annuities as they should improve their income in the future. That said it's difficult to be precise as to how many people could improve their retirement lifestyle by exercising the OMO. We estimate that around 40% of people would qualify for enhanced rates due to their lifestyle or health and yet only 10% of retirees actually purchase an enhanced or impaired life annuity.

Dicks: Customers will have many reasons for purchasing a fixed term annuity, among these will be health concerns and uncertainty over legislation.

Footitt: Fixed-term, or temporary, annuities are interesting beasts. These are a form of unsecured pension, and currently only have one provider - Living Time - in that slot. The drawback with them is that they do not have the entry that they need into alternatively secured pension, and perhaps that's why a bit of noise is being generated around 'effective compulsion' to (lifetime) annuitise by the age of 75.

A more attractive form of fixed-term annuity sits in the secured pension space, where one alternative is Canada Life's Annuity Growth Account. This is where a five-year tranche of a lifetime annuity is secured at a much lower purchase price than a full conventional lifetime annuity. Consequently, the majority of the purchase price remains invested for five years with the potential to buy a better income in the future, as well as one that can change to suit the annuitant's new personal, health and financial circumstances.

At this juncture, I feel that whether or not the cut-off between USP and ASP is raised beyond the current age 75 is a peripheral issue.

Smith: Fixed term annuities offer customers the opportunity to take a guaranteed income and defer buying a lifetime annuity. They will appeal to customers willing to take on the risk of annuity rates moving against them in future. While it is true that customers may benefit from an impaired life annuity, it is also true that they may remain in the healthy population subject to standard annuity rates. It is worth remembering that standard rates will deteriorate due to future longevity improvements and the increase of impaired lives moving out of the standard pool all other things being equal.

How can annuities be used to combat rising inflation in retirement?

Brown: Escalating annuities do have value but one should be careful of the cost of doing so. Individual planning rather than a blanket approach is the key. I would say it is more appropriate to consider spouse provision as that is an area of annuities that does deserve focus.

Dicks: The current annuity offers many different escalation alternatives to protect the customer against inflation.

Footitt: By people saving enough for their retirement and building in inflation-proofing when annuitising either at a fixed rate, or linked to an index, such as the Limited Price Index (LPI), Retail Price Index (RPI) or National Average Earnings (NAE).

Smith: The simplest way is to buy an index linked annuity. However, many customers are put off by the low starting income.

Alternatively, investing in asset-backed annuities (either with-profit or unit-linked) offers exposure to real assets which will help combat the effects of inflation. Conventional annuities invest mainly in assets such as bonds. While the purchase of a level conventional annuity probably offers customers the highest starting income, it provides no protection against inflation. On top of this, we all know that people are living longer which means that they need to give more thought to the perils of inflation as they could spend longer in retirement than they did working! Ensuring that the purchasing power of customers' incomes is not jeopardised should be paramount when advising on the most suitable retirement product.