August 2008

Risky business

There is no argument to suggest that drawdown will eventually replace annuities, although I recognise that there is a role for income drawdown and variable annuities for the right customer at the right time.

I think it is important for me to define up-front what I mean by annuitisation because I don't use the term, as you might expect, to mean buying an annuity. I use annuitisation to indicate the process which puts capital at risk in exchange for receiving a mortality cross-subsidy to maximise lifetime income. Annuitisation does not have to take place at the time an annuity is bought since provision of a death benefit can delay the extent to which capital is put at risk.

Annuitisation can work within annuities invested in unitised funds thereby enabling a higher lifetime income in exchange for giving up capital on death. I therefore don't agree with any suggestion that drawdown will replace annuities simply because drawdown can invest in equities and enjoy the benefit of the equity risk premium.

In my view the critical difference between annuities and drawdown is the impact that annuitisation has on the trade-off between income and death benefits. Higher death benefits result in lower income and vice versa - you can't magic something out of nothing or magic the risk away.

One major reason why drawdown will not replace annuities is the size of pension funds. Over three quarters of current funds are less than £30,000 after the 25% tax free cash has been taken. These fund sizes are such that most people do not have scope for drawdown. Or perhaps drawdown enthusiasts see a way of charging the extra costs needed for ongoing advice and extra administration in a way that is acceptable and gives value to consumers and complies with TCF?

Of course I accept and hope that fund sizes will increase significantly in the future and this may lead to higher drawdown take up. Regrettably I suspect that there are always going to be a lot of pensioners with insufficient funds to be able to afford the drawdown route, and who will get better value from buying a new generation annuity product.

Integral role of annuities

Annuities are an integral part of a generous UK pensions tax regime. On balance it is perhaps not unreasonable for the Government to expect annuitisation of 75% of the fund.

The benefit of annuitisation at age 65 is relatively small. The chance of dying at age 65 is less than 1% so an annuitant receives a mortality cross subsidy of less than £1,000 in that first year for putting £100,000 capital at risk. This is not very attractive and does not lead to a significant increase in lifetime income. Most pensioners would rather retain control of their capital and, if they are unlucky enough to die, feel that their family will receive some benefit from their pension fund.

As people get older so the benefits of fully annuitising grow exponentially and the impact of investment returns diminishes. Let's just suppose that a pensioner was allowed to delay annuitisation beyond age 75. For a male aged 85 deciding to annuitise today with no death benefit, the annuity would provide a guaranteed income of around 20% of the capital. The mortality cross-subsidy overshadows any investment return, so fixed annuities with their bond investments increasing, become the optimal solution.

Pensioners need to be able to insure against living too long. Even those with extensive wealth may like to consider annuitisation to avoid the risk that they will not be able to leave an inheritance at the level they hope because the money will be needed to supplement pension income if they are lucky enough to live a long time.

It is not a question of if but when pensioners should fully annuitise; remembering that this is not necessarily when the annuity is first purchased. Pensioners need a retirement annuity account which limits the fund at risk in early years but retains mortality cross-subsidy in later years to provide the essential longevity insurance. This can be achieved by providing some death benefit in the early years when the impact of the cross subsidy is small, while ensuring that by the time that annuitants are into their 80s, their fund is annuitised and receiving the benefit of the mortality cross-subsidy. Ideally the death benefit should be a lump sum money-back guarantee to overcome pensioners concerns of losing their capital on early death.

Annuities have a central role as part of any holistic retirement income plan and offer the most effective and economic way of maximising lifetime income.

Pensioners using income drawdown are exposed to a number of risks:

- they risk outliving their capital, or more likely having to reduce their income as they get older

- they are exposed to investment risk such as drawing down income when markets are depressed, which can have a significant impact on overall income levels

- they are exposed to the risk when they decide to purchase an annuity

- they expose themselves to 'mortality drag' and the risk that mortality improvement assumptions will be strengthened by the time they come to switch to an annuity.

Of course these risks can work in pensioners' favour, but the key point is that only those who can afford to take these risks should do so. Given the lack of adequate pension savings this is unlikely to be a majority.

Tom Boardman
Group Policy Development Director
Prudential