Postcode lottery

The use of postcodes in calculating annuities has always been controversial. Helen Morrissey finds out the pros and cons of using this approach

Postcodes have been used for years in the pricing of many insurance products. However, when Legal & General recently announced a pilot project where postcodes would be used in pricing annuities many providers and IFAs denounced the approach as "crude" and a "blunt object". However, it's worth bearing in mind that the use of postcodes in this way is nothing new. Insurance company MGM used postcodes when pricing annuities while Norwich Union has also looked into their use in the past. So what benefits can this approach have and why are Legal & General looking at it now?

"We've been looking at ways of improving pricing accuracy in the annuity market," says Tim Gosden, head of product development - annuities at Legal & General. "At the moment the vast majority of annuities are bought on a conventional basis with only around 8% currently being bought on an enhanced basis. So the vast majority of annuities are bought on a basis which only uses age and sex to work out life expectancy. We felt that as people live longer there is a need to be more accurate in the pricing of these products."

The premise of postcode annuities is that where someone lives can be an indicator towards life expectancy. For instance the average life expectancy of someone living in central Glasgow is lower than for someone who lives in Kensington. Therefore by taking the postcode into account the person living in Glasgow would get a better annuity rate. According to the pilot qualifying annuitants could get an income uplift of up to 3%.

The two month pilot carried out in partnership with IFA firm Hargreaves Lansdown has yielded some interesting results according to Gosden with just under 20% of applicants qualifying for an uplift in income. Legal & General will assess how successful the pilot has been before deciding whether to launch the concept to the market.

Tom McPhail, head of pension research at Hargreaves Lansdown agrees saying that the approach enables providers and IFAs to offer more to their clients.

"Both we and Legal & General have been very happy with how it's gone," he says. "It's enabled Legal & General to put more competitive rates to qualifying customers and gave us another tool to offer our clients. If the client lives in Kensington then it's not applicable but if they live in Glasgow then it's another option we can offer them. It's also worth saying that there are myriad other options that we can offer the client such as smoker annuities. Of course you don't get to live longer just because you move to Kensington it's just that those that live there on average tend to live longer than those in Glasgow. If it gets people interested in getting best value from the pension it is great and if it encourages the open market option then that is brilliant."

According to Phil Naylor, director of compulsory purchase annuities at Legal & General, the biggest challenge faced was to build a modelling tool that could effectively deal with the vast amount of data needed to calculate the annuity rates. However, he is confident of its accuracy and success.

"Building the model itself was a big challenge which has taken a long time to put together," he says. "You need a lot of modelling sophistication in order to develop a postcode model and the one we've developed goes down pretty much to individual postcodes. There's a lot of external and internal data used and we feel comfortable using it."

A crude approach

However, while many stand to benefit from the use of postcode annuities there are many who have decided against using the approach. Norwich Union looked at postcode annuities in 2003 but decided not to proceed.

"It's a crude way of underwriting," says Scott Brown, head of marketing annuities at Norwich Union. "It's no big secret that people who live in different locations live different lengths of time. What it doesn't look at is the reasons why some people live longer than others. It's not simply because someone lives in Glasgow and someone else lives in London. It's the lifestyle that goes with it that drives this. You can have people living next door to each other with very different life expectancies - one could be a marathon runner - the other a couch potato."

Stuart Bayliss, managing director of Annuity Direct agrees, saying that the Legal & General pilot does not go far enough.

"Legal & General specialise in small annuity funds and want to refine their approach," he says. "However, an uplift of 1.5% in exchange for 10 years less life expectancy does not represent good value and I think it's just a token gesture to reposition the company in the small funds market."

While the small uplifts in income with postcode annuities are welcome they are no substitute for a full underwriting process which could give annuitants a much larger uplift in income, says Nigel Barlow head of retirement income solutions at Just Retirement.

"If you are gathering information about the client and you are asking them about their health you instantly have more individualised information," he says. "The reason why someone in a certain postcode would qualify for a postcode annuity is because they are likely to have some kind of condition or lifestyle factor that reduces life expectancy. If you have specific information then you can target the annuity more precisely.

"I reckon the underwriting will be fairly fluid in the Legal & General pilot but in general it seems to be a broad brush approach. If you have an individual condition then you are likely to get a better annuity by declaring that condition."

Alternatives

So if the use of postcodes is crude then what other factors can annuity providers use to calculate their rates? According to Barlow the job the annuitant does could provide valuable information regarding future life expectancy.

"One thing I would say about Legal & General's approach is that it has raised the profile of annuities and if that raises people's awareness then it's a good thing," he says. However, I do think that employment would be a good measure to bear in mind. If you work in a particular industry then it's possible it would have an impact. However, the way the market is now it's easier than people think to get a quote for an enhanced annuity. It's relatively easy to fill in a medical questionnaire - they aren't that daunting and your client will get an annuity based on their tailored circumstances. However, people don't like to disclose their medical conditions but it is an area where the adviser can really make a difference to their client's income."

McPhail agrees that full individual underwriting is a more accurate way to go but highlights the fact that it is a much slower process and that postcodes do have a valuable role to play.

"The virtue of the postcode approach is that it's much quicker," he says. "There's an instant enhancement as there are no forms to fill in or delays while you wait for medical information. I know the idea has caused some concern among those who feel that some clients might be disadvantaged but there are no reductions - only enhancements here. I think it's important to bear in mind that this is one more mechanism in a range of options that can be used to price annuities. It wouldn't surprise me to see more of this in the future. They may be crude but they are effective."