The Open Market Option
by Dr. Ros Altmann
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Annuities are a ‘special case’ in terms of financial products. They are the only financial products which you are legally obliged to buy (you must buy one in order to covert your pension savings into pension income, at least by age 75). They are also the only financial products which, once you’ve bought them, you can never change.
It is, therefore, obviously crucial that people should get the best rate they can, since they will be stuck with the rate they take for the rest of their lives. That is why pensions nowadays offer people the option of shopping around for the best rate, once they have decided which kind of annuity they want. People don’t have to take the annuity rate offered by their pension company, but can take it from another provider if they wish. Unfortunately, however, most people don’t do this and, therefore, don’t get the best value from their many years’ worth of savings.
There are several reasons why people don’t take their Open Market Option (OMO).
A. Why don’t people take the Open Market Option?
Currently, most people do not shop around for the best annuity rate and often just take the rate offered by the provider who managed their pension fund. There are many reasons for this.
1. People often don’t realise that saving for a pension is not the same as actually buying the pension.
Most people settle for the annuity offered by the company which invested their pension contributions on their behalf. But being good at investment and providing good annuity rates are as different as football and cricket – being good at one does not automatically make you best at the other.
2. Some contracts do not allow people to take OMO.
Some older pension contracts actually don’t allow people to take their annuity from a different company. Such pensions are not permitted any longer, but there are still some old ones with such restrictions. It would certainly be much fairer if legislation could be introduced to allow people to move to another company, if their provider was not offering a good rate. Even better, it would be helpful if the providers themselves agreed to such a change, without legislation!
3. People often don’t understand what ‘exercising the open market option’ actually means!
The ABI has introduced its ‘Raising Standards’ initiative to ensure that all insurance companies write to their prospective retirees to inform them of their right to take OMO. However, there is no requirement to tell people this in ‘plain English’ i.e. to tell them that, if they don’t shop around for better rates, they may be stuck with a lower income than they could get elsewhere for the rest of their lives! (This initiative is also only voluntary).
4. It is much easier NOT to take OMO.
From a practical perspective, if you just accept the annuity offered by the company managing your pension fund, all you have to do is sign a form and send it back. If you want to take an annuity from another company, this entails filling in lots of forms and complying with all sorts of regulations. This, alone, is enough to put many people off shopping around. In particular, anyone who does not have an adviser to help them is highly unlikely to be able to cope with all the form filling that is needed.
5. People need advice on where to find the best rates.
Most people wouldn’t have a clue about how to shop around for the best rate for their annuity. This can actually be done on the web or even on teletext, but it is not easy and usually requires confirmation phone calls to be made. The annuitisation process is so complicated in most cases (largely due to the complicated regulations which govern pension plans in the UK) that people can’t work things out on their own. This typically means that anyone with moderate or small capital sums will not get any advice and will, therefore, not be able to take advantage of the OMO. Most annuity advisers, in practice, have a minimum level of £50,000, below which they believe it is not worth their while to give advice. Since the average annuity size is £23,000, this means it is only the richest who will get help and get best rates.
6. Sometimes, firms charge a penalty for people who transfer their funds to another provider.
In the case of Equitable Life, for example, there was a 20% reduction in people’s pension pots if they moved elsewhere.
7. The process of receiving confirmation of pension fund values and of transferring pension entitlements to another provider can often take so long that people simply don’t want to or can’t wait and need to annuitise straight away.
Some firms are extremely slow at sending out pension fund information, or executing transfers. Even advisers have been know to have to beg for payments to be made. Many pension providers have very out dated administration systems and some are still doing this aspect of their business by hand! If a company only has a few maturing pensions per week, it has not been worth their while to invest in the back office systems needed to ensure they can deal with these maturing funds efficiently.
8. People sometimes lose track of their old pension entitlements.
When people change jobs, they don’t always keep proper records of their pension entitlements and it is only when they approach retirement that they start to look around for their old funds. This will probably become an increasing problem over time, if it is not addressed. The reason this may prevent people taking OMO is that, by the time they find their old entitlements, they may not have time to shop around and may just need to take an income.
B. What could be done to ensure people do actually take OMO?
1. People need help to make this complex, irreversible decision.
The best way to ensure that people are able to make the right choice of annuity and then get the best quote for that type of annuity is to make it compulsory for them to receive advice before they buy. They need someone to hold their hand through the process. For an adviser who is used to buying annuities, the process of finding the best rate is familiar, but to a person coming up to retirement, who has never had to do this before, it can be a daunting task. Automatic provision of advice and finding them one of the best rates in the market should solve this problem overnight. The important fact to note here is that people are currently paying for advice, even though they may not get it. Insurance companies deduct 1 – 1.4% of the pension pot for ‘commission’ even if there is no adviser to pay it to! So, although people desperately need advice and are paying for it, they don’t get it! If they did get it, they would often be able to have a higher income for the rest of their lives, would be more likely to get the right kind of annuity and would have someone to help them deal with all the complications of buying an annuity.
2. Set up an Annuities Exchange.
If there was an easily accessible service which carried all the annuity rates in the market, people could compare rates readily. IFA’s can already use such services but these are only about 90% reliable and they still need to phone for confirmation. Many industry participants are actually working on setting up such a service and it could be ready in a few months’ time. Providers would all post their rates daily and the adviser would just need to enter the relevant requirements (such as age, gender, single or joint life, frequency of payment, escalation requirements, guarantee period etc) and the system would list the annuity rates quoted for those criteria. In theory, if such an exchange existed, people could actually find the rates themselves. I would argue, though, that they still need an adviser’s help. Firstly, to find the right kind of annuity and secondly, because it may still be too difficult for many people to do this, when they are so unfamiliar with all the issues involved.
3. Require providers to offer competitive rates.
There is currently no requirement on the ceding provider to offer decent rates for its annuities. If it were a requirement that providers must offer one of the top rates in the market, this would mean everyone would be more certain to get better value from their annuities. There could be a default option for people who refuse to take advice, which ensured that, although no-one had helped them find the right kind of annuity, they would at least be offered a ‘standard annuity’ (perhaps single life, level, 5-year capital guarantee) at a top rate. At the moment they could get the wrong annuity AND a poor rate!
4. Educate people to understand that the action of saving for their retirement is separate from the action of buying the pension.
The FSA is trying to help with this and has produced some very useful booklets. Much more is needed here, and the Press certainly has a useful role to play in making people aware of the need to be careful to buy an annuity from a company that is offering good rates.
5. Change legislation to allow people in old style contracts, which do not allow them to shop around, to actually get OMO.
6. Describe the process of OMO in ‘plain English’.
The insurance industry seems poor at using language that ordinary people can understand. They describe the simple concept of ‘shopping around for the highest pension to live on for the rest of your life’ as ‘exercising the Open Market Option’! This phrase means nothing to most people. Not only this, but every insurance company can call the action of exercising OMO something different. There is no common wording on annuity forms, no standard forms to help people understand what is going on. Some call the process ‘vesting a pension’, some call it ‘buying an annuity’, some call it ‘buying a pension’ etc.
7. Require standard forms
Currently, each provider has their own forms for the process of buying annuities or informing people of maturing pension rights. Each of these forms is different and this makes it so much harder to actually work out what the person has. If all forms were the same, people would know where to look for the information and would be able to easily compare what their entitlements and options were. This would also make any advice process much easier.
8. Simplify the rules governing annuities.
This is a huge problem for both those buying and those selling annuities. There are so many different and often conflicting rules governing annuitisation of different parts of one’s pension, depending when the contributions were made, that the whole process has become fraught with complications. Each different pension regime has different annuity requirements and it would be enormously beneficial if the rules could be harmonised, to provide a single set of regulations. This would involve having the same tax free lump sum, same escalation (if any), same spouse cover etc. Removing the anachronistic protected rights requirements would also help.
9. Make it easier for people to take OMO.
It would be helpful if forms were standardised and compliance regulations could be eased, to allow the process of taking OMO to be almost as easy as not taking it. Of course, if everyone had an adviser, these problems would be less acute anyway.
10. Ensure that providers improve their administration systems.
Currently, the back office systems of many pension providers are not functioning well. It can take months for some companies to transfer the pension sum to a different annuity provider and this can mean a significant change in annuity rate from the time the person first receives his quote. There should be a standard maximum time (say 2 weeks?) within which funds have to be remitted after request. At the moment, apparently, IFA’s often have to chase companies many times to send the payment and the whole annuity process is delayed due to these administration problems. There is an initiative underway for this by the ABI, but it is voluntary, rather than mandatory.
11. Improve pre-retirement education and start the planning process earlier.
People currently wait until very close to retirement, before making their financial plans. This often leaves insufficient time to make the necessary arrangements to get the best pension.
12. Prevent companies from charging penalties to people who buy their annuity from a different company.
13. Help people keep track of old pension entitlements.
People often lose track of their old pension entitlements and it would be very helpful if some mechanism could be found to transfer a record of old pensions when moving employment, or changing arrangements. This could be a clearing house (maybe centralised in Newcastle) like a registry of pension entitlements. In order to confirm their entitlements, people need deferred pension certificates, but this often takes some time to track down.
14. Raise the commutation limit.
If the sum saved in a pension is very small, and the person has no other pension to add it to, it would be uneconomic for advisers to offer any service. Currently, it is only possible to take cash from the pension fund if the annuity it could buy is under £260 per year. This ‘commutation level’ has not been changed for a long time. It is not economic to annuitise very small sums and there is certainly a case to consider raising the level of commutation for triviality from its current £260 per year – especially as stakeholder sums could well often be very small and give poor value pensions.
C. What is the effect of people not taking OMO?
There are often enormous differences in the rates offered by insurance companies for their annuities. It is quite normal for the difference between the top rate and 10th rate to be over 10% and the worst rates can be 30% or more below the best. There are times when insurance companies do not want to write annuity business. They may not be able to cope with the reserving requirements at that point in time and, therefore, they drop their rates to discourage business. But, people who do not shop around often end up taking these rates, without realising how much better they could do. By helping them to use their OMO, they could have much more money to live on for the rest of their lives.
Here are some examples.
What difference does the inability to shop around make to the average personal pension investor approaching retirement? Here are some examples:
(i) A man aged 60, with a pension pot of £25,000, could buy a pension of around £35 per week from the best provider, but only around £30 per week with a 15% gap, so he would lose over £5 per week for the rest of his life by not shopping around. If he lived for another 20 years, he would have lost over £5,000 by not taking the top annuity rate.
(ii) A man aged 65, retiring with a £50,000 pension pot, could expect to receive. about £80 per week from the top providers. If he was in poor health, he could well get over £100 per week from an impaired life annuity and, if he lived only another 10 years (instead of the average life expectancy for his age of about 16 years) he would have lost out on well over £10,000 of income during his retirement
(iii) A woman who retires at age 60, with a £10,000 pension pot could expect to receive around £13 per week from the top annuity providers, but may end up with only £11 per week, if she does not shop around. If she lives for another 25 years, she will lose out by over £2,500.
(iv) A woman retiring at age 60 with a pension investment of £100,000 could lose £20 per week by not shopping around. If she lived to be 90 – by no means atypical – she would lose a total of £31,200.