October 2007

For your consideration

Choosing the right annuity is an important decision and can have a real impact on a client's quality of life in retirement. We believe there are three key considerations an adviser must bear in mind when guiding their clients on the right product to buy. For the purposes of this article I have chosen to focus on the issues surrounding conventional, investment-linked and temporary annuities.

- What is the client's attitude toward investment risk?

The size of the pension fund relative to the desired pension income significantly determines the retiree's flexibility of product choice. This can be seen in how a client reacts to suggesting a lower initial income to protect the real value of the pension for instance. Alternatively it's also worth suggesting the same outcome could be achieved by using an investment-linked annuity and assuming an initial low investment return. The acceptability of the pension income going down from one year to the next also gives a clear indication as to the retiree's true willingness to take risks.

- Is the retiree prepared to make decisions based on the probability of their circumstances changing?

The certainty of outcomes needs to be discussed. Willingness to countenance lack of certainty obviously leads to investment risk being considered, but it is also key in assessing the possibility of a temporary annuity being appropriate. Those retiring between 60 and 65 may predict on a 10-year horizon the possibility of one or other of a couple becoming ill or dying. Equally, their parents could be expected to die, potentially leaving an inheritance. Others may have significant financial commitments early in their retirement or be expecting to release equity from their property by trading down, etc. If the probability is viewed as high by the retiree then a temporary annuity with the possibility of income levels up to 120% of standard annuities could be attractive.

- How long is the pension income going to need to last?

The health of the individual retiree or their partner is obviously central to this, but enabling the retirees to understand what average life expectancies are can prove quite tricky. The average life expectancy for a 65-year-old man with a pension may be 23 years, but if the retiree is in perfect health, upwards of 35% of the people making up that average are irrelevant to him and his average life expectancy would be greater. For the choice of the annuity the health of the retiree or their partner is often determinant. It is vital that the retirees understand that, for the first time in obtaining an insurance product, disclosing every aspect of their ill health will benefit their lifetime income.

Once the answers to these three areas are established, we can examine the choices open to the client.

Conventional annuities

Ensuring the retiree is not eligible to benefit from a guaranteed annuity rate with any of their existing pension providers is an important exercise. The retiree would often not know and, sadly, the information they would have received from their pension provider may not make it clear whether they have a guaranteed rate or not. Enquiry and review are vital.

The open market option is a right that should be exercised in all cases, even where the conclusion of exercising that right is that the pension fund should stay with the existing pension provider.

The average improvement in pension income obtained by specialist annuity advisers is around 12% with retirees most likely to exercise the open market option where improvement of 3% or more is available.

The differential between standard rates and enhanced or impaired rates has increased significantly in recent years with smoker rates between 10% and 15% higher than standard. This is because standard rates have been reduced partially on the assumption that those eligible for enhanced and impaired rates are getting them, meaning anyone who is eligible who doesn't take advantage of their availability is hit by the double whammy of being likely to die earlier than average but receiving an income reflecting a higher than average life expecancy.

One further issue in relation to impaired annuities is the importance of obtaining illustrations from the whole market. Impaired annuities are available for those with more severe or complex illnesses. They are individually underwritten by the provider who assesses the risks. The results are very different from enhanced or standard annuity quotations. It is not unusual for one company to be 15%, 20% or even 25% higher than the second highest company. Also, there is no way of predicting which of the impaired providers is likely to be the highest. Therefore, completing the common application form now being used by all impaired life companies is an important service to retirees.

Investment-linked annuities

The key to acceptability of investment-linked annuities is the willingness to accept a flexible income. However, retirees need to review investment risk understanding that conventional annuities, while offering certainty, have investment risks of their own.

That is that you are investing 100% of your retirement funds in gilt and fixed interest investments in order to provide an income for a period of up to 30 years. Investment returns over such long periods show that having a broader range of investments would be beneficial.

With-profit annuities could prove to be popular in this respect as they offer a balance of investments along with some protections against falls in value.

Temporary annuities

It is probably unfortunate that to date there is only one standard temporary annuity provider and no enhanced or impaired option. This absence of competition or multiple providers is in some cases leading retirees to not give full consideration to the possible advantages that deferring the purchase of the lifetime annuity could have as a result of changes in circumstances during the early years of retirement. A further fundamental shift is occurring in the behaviour of retirees. A growing number are making retirement a process where a movement to working less and taking some pension benefits occurs over a number of years. This will inevitably mean appropriate advice will leave retirees with much more complex pension income sources through the use of multiple products.

Ian Owen
Chairman
Partnership Assurance