October 2007

Third Way Products

Keeping the balance

The UK retirement income market is changing rapidly as product innovation creates alternatives to the traditional default options of conventional annuities and unsecured pensions.

While there continues to be a place for these more mainstream options, both have disadvantages that have paved the way for a new generation of products. IFA commentators and the media are talking about a so-called "third way" or "middle way" but in reality the developments in the market are wider than that. At MetLife we believe that innovation in the retirement income market is so rapid and diverse it does not make sense to put all the innovators in one group. Diversity is now the watchword in the market and should be the way forward for advisers.

Minimising risk

What has been missing from the UK market are solutions that balance flexibility with minimising risk and offering guarantees. New products now available enable savers to keep their funds invested until 75 and beyond without the risks inherent in drawdown or the inflexibility of traditional annuities.

Developments in the market chime with changes in society. Increased longevity - the average 65-year-old man can now expect to live to 81, according to the Office of National Statistics - means there is more need for flexibility. Guarantees have a role for clients who may be retired for as long as 25 years or more.

Arguably, such products should actually have formed the bulk of the market and if anything, the current traditional suite of solutions should have been sidelined as mere niche-type products. As a result, the market for innovative products looks positive in the coming years. However, there is still a major awareness gap around how they work and the uses to which they can be put.

Tried and tested

It is important to note that the new products on offer are not untried or untested. What the UK pensions market will see going forward is similar to the experience of the US. Indeed, those providers leading the innovations in the market including MetLife have all drawn upon their US experience to manufacture new products for the UK.

Currently the products are available to the wealthier end of the retirement market, but over time, these can be expected to become more widely accessible as product development and innovations take effect.

The crucial element of all the innovative products is the guarantee although there are differences among all the new products.

Guarantees have played a major role in pension provision for some time in the US. In order to be believable the guarantees have to be provided by companies with the financial strength to underwrite them.

The guarantees can take several forms. For example, it might be investment returns that are guaranteed or 'locked-in'. Or it might be the interest rate applied to the pension pot to provide the pension income that is guaranteed. Or it might be a combination of both.

Guarantees can be applied at any of the three stages of retirement saving - accumulation of assets, at-retirement and in-retirement. In the first stage, guarantees can be applied to lock-in gains some time ahead of the intended retirement day. This might be achieved by investing in guaranteed funds or perhaps through a trustee investment plan (TIP) which allows investment gains to be locked-in periodically, in some cases up to 15 years ahead of retirement day.

However, guarantees really come into their own in the second, or drawdown, stage of pension provision. Again, it might be investment returns that are locked-in periodically as the pension pot continues to be invested while drawing down an income as well. It might be that a percentage of the pot at retirement - usually 5% - is guaranteed to be provided as a pension income for the period of drawdown or life, even if the pot itself reduces to zero. Or it might be that the pension income is guaranteed to rise in line with locked-in gains in the pension funds that are determined at set periods such as three to five years.

The third stage of retirement most commonly means taking out a traditional annuity by the age of 75. However, even here, there are now flexible annuities enabling the portfolio to continue to be invested with similar kinds of guarantees to those available in the drawdown phase.

The difference now is there are alternatives to the traditional products that still dominate the market. The ability to time the switch to an annuity is key because of the volatility in annuity rates driven by variations in interest rates over time as well as investment conditions in financial markets. Some solutions now allow a US-style annuity to be taken out that continues to afford investment flexibility after 75, including the use of guarantees on the investments and income. As a result, asset growth and protection can be continued beyond anything possible previously.

Between the old options of traditional annuity and drawdown there is scope for all kinds of innovation. What is more, as IFAs themselves become more sophisticated and develop along the lines of 'new model advisers', these products will require a closer and longer-term relationship with clients. This can only be beneficial for all parties concerned.

Christopher Reed
UK head of Retirement & Savings Business
MetLife Europe