April 2008

Who's way is it anyway?

When HM Government issued its consultation paper The Annuities Market at the same time that Gordon Brown, the then Chancellor of the Exchequer, released the 2006 Pre-Budget Report, it expressed the Government's wish to encourage the development of new retirement benefit products, the so-called "third way" arrangements. I well remember the widespread dismay, when paragraph 5.66 of the 2007 Pre-Budget Report, was discovered:

"5.66: following a commitment in the 2006 Pre-Budget Report, the Government has consulted widely with industry on tax barriers to the further development of 'hybrid' decumulation products, which combine an element of drawdown with a guaranteed income. The Government has decided not to change the tax rules as this would add complexity to the tax system and potentially benefit only a small number of consumers with large pension savings."

As a result of this move, these "'hybrid' decumulation products, which combine an element of drawdown with a guaranteed income" seem destined to remain a product only attractive to "a small number of consumers with large pension savings."

So whither the "third way"?

Almost since the beginning of specific pension benefit provision, non-governmental retirement income has been provided by an individual pension annuity or an occupational scheme pension. The Finance Act 1995 introduced a bold new conduit for this income as personal pension fund withdrawal that allowed an individual to defer the purchase of a pension annuity until the age of 75.

Today, neither of these two forms of accessing an income in retirement is wholly satisfactory in itself.For a good many individuals, nevertheless average pension savings are still so low that many people simply have no choice other than to purchase an annuity.

In the 1990s, variable annuities with optional guarantee riders began to be developed in the United States of America offering options to fixed annuities in that market. It needs to be said at the outset that these products are not annuities as we know them, and they are not variable during their lifetime. What they are in fact are unit-linked savings and investment policies with embedded guarantees.

MetLife launched the first pension "variable annuity" early in 2007 since then several other offerings have arrived almost exclusively through American-backed UK life offices.

Why the "third way"?

In June 2007, Billy Burrows (William Burrows Annuities) wrote in his Blog:

"Product developers have tried to design annuities that have flexibility but the current annuity regulations simply do not allow this. All credit to those companies that have designed innovative annuity products such as AGA*, FLA** and Open Annuity (now no longer accepting new business) but they have not gained mainstream appeal.

The new "third way" products approach the problem from a different angle. Instead of trying to make an annuity look like drawdown, they are trying to make drawdown look like an annuity by providing a guaranteed income for life."

The post third way period, dubbed the "middle market" in some quarters, now seems to have focused minds on the dilemma that increased life expectancy and diminishing interest rates, in combination with low pension savings, makes a decent guaranteed income for life in retirement very difficult to obtain. Nevertheless, if you study the basic lifetime annuity in any depth, it remains excellent value for money.

To guarantee or not to guarantee?

Equally, drawing retirement income directly from an investment fund largely composed of asset-backed investment instruments is risky. Risk is particularly high in volatile market conditions especially where these are prolonged.

However, research published by the Fidelity Retirement Institute showed some interesting figures that would question the value of the so-called Guaranteed Minimum X Benefits (X could be income, death, withdrawal or accumulation) (GMxBs). For example, the cost of guarantees applied to a £50,000 fund invested at 65 over 30 years would "at the median (...), be worth £21,395 in a variable annuity but significantly more than double this amount if invested in a non-guaranteed fund even if the same level of income had been paid out" the guarantee effectively costing "£31,227 - more than half of the initial capital."

Will your money die before you do?

Given that third way products are commonly positioned for a male retiring at 65, what are the chances of the money dying before they do?

It all depends when the income guarantee may be required. "There is a modest chance of the fund running out in 20 years", however, with a GMIB, "payments would be made for a further 10 or 15 years, possibly more." (1Fidelity International Viewpoint - October 07) Contrast this with the standard life expectancy for 65 year old males of 16.93 years '(2Period expectation of life based on data for years 2004-06' Interim Life Tables, United Kingdom), what value a GMIB?

From a third way product point of view, a combination of unhelpful pension legislation, clear indications that HMRC do not wish to "add complexity to the tax system and potentially benefit only a small number of consumers with large pension savings", and the dubious value of GMxBs leads me to the conclusion that variable annuities are unlikely to make much headway in the UK pensions market in the foreseeable future.

It is widely accepted that with increased longevity comes an end period of life spent in failing health. The overall average life expectancy for a 65 year old male in the UK in 2003 was 16.4 years, however it was only 9.4 years free from limiting long-standing illness or disability. '(3Health Expectancies in United Kingdom 2003' Health Statistics Quarterly - Spring 07) Therefore the need for more flexibility in retirement income provision is more important than a guaranteed minimum income benefit that may not be required in the majority of instances.

*AGA: Canada Life Annuity Growth Account

**FLA: Prudential Flexible Lifetime Annuity

Bernard Footitt
Technical Support Manager - Pensions
Canada Life