Modernising Annuities – What can we do?
by Dr. Ros Altmann
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I have two suggestions for making the annuity market work better for the majority of people who buy annuities. These are:
1. The pension provider must ensure that everyone buying an annuity has received at least a basic level of financial advice (preferably independent) before they buy. This advice must include shopping around for the best rates. There would be a default option to ensure that the seeding provider is obliged to provide a competitive rate.
2. Revenue rules should be relaxed to permit annuities to be offered with a ‘money-back guarantee’ – if the annuitant dies before the full amount of the capital sum used to buy the annuity has been paid out, the balance goes to the person’s heirs.
The Government has opened the door to suggestions for making the annuity market work better. Annuities have received such bad press lately and many are worried that this will put people off saving for their retirement. In truth, annuities are actually an extremely good product and there is no better way for someone to ensure that they will never run out of money, as long as they live. One of the problems we face today, though, is that annuities are having to support people for a ludicrously large number of years. When originally designed, a ‘normal’ period of retirement would be 5 or 10 years, and, for this length of time, annuities are great. But, with more early retirement and increased longevity, they are now supporting people for 40 years or so! This suggests that some changes need to be made, to adapt to today’s environment and the Government has suggested ways of increasing the flexibility and transferability of annuities, to try to address the problem of lengthening retirement periods. (Ultimately, of course, the period of retirement is going to need to be shorter, since it is such a huge waste of resources to force people to stop working when they still have many more years to live).
There is an urgent need to restore confidence in annuities. It is, of course, essential that people keep saving to provide for their future otherwise the ongoing shift away from final salary pension schemes could leave many future pensioners without a decent income in retirement. If the Government is to achieve its aim of having 60% of retirement income come from private sources by 2050, money purchase pension arrangements will need to increase substantially from today’s level. The current attitude to annuities will make this highly unlikely.
I am suggesting a package of measures, which will not cost the Government a penny, which could radically improve the amount of pension most people receive from their annuity, would ensure they get good value from their accumulated savings and would also ensure that, if they die young, they need not lose all their capital, but could pass it on to their heirs. Although I believe that one of the problems with annuities is that they are trying to provide pensions for retirement periods that are too long, there are many other problems with annuities which could easily be addressed and would benefit the vast majority of people. The pressure groups for reforming annuities are all focussing on issues which would only benefit the better off. Raising the age by which you must buy an annuity from 75 to 80, buying an index-linked annuity up to a level that would ensure no need to receive means tested benefits and freedom to do what you like with the rest may sound sensible ideas but, in practice, they are just not relevant for the vast majority of people who are buying annuities. The average size of fund that buys an annuity is below £25,000 and it is only the top 5 or 10% of annuitants – those with very large capital sums – who could afford to buy an index linked annuity to take them up to the Minimum Income Guarantee level, or could afford to wait until age 80 before annuitising.
No-one is helping those with small or moderate capital sums to get better value from the annuity market. And there is so much that could be done here.
In the financial products arena, annuities are very much a unique product. I think they need to be considered as a ‘special case’ for two reasons:
– they are the only financial products that a person is legally obliged to buy and
– they are also the only financial product which, once bought, can not be changed for the rest of your life!
Since this is the case, surely it is essential that we ensure people make the right choice of annuity and get the best deal they can before they make this irreversible decision. Unfortunately, though, most people do not understand what annuities are and have no idea how to get the best rate. People need help to select the right annuity for their circumstances and to find the best rate available for that product. But it is only those people who have large capital sums who actually receive any advice and by far the majority of annuitants are left to make this decision on their own. The result is that often people buy the wrong type of annuity (married or co-habiting people often take a single life annuity, because that tends to be the one that is most often quoted and looks the highest amount), or that they do not get a competitive rate for their annuity (most people do not shop around to see who is offering better rates than those they are quoted by the company managing their pension pot), or both. Given the irreversibility of this decision, such a situation is a cause for concern.
But it is even worse than this. Although people obviously need advice and assistance before they buy their annuity, and although the majority of people never get any proper advice, people who buy an annuity are being charged for advice anyway – even if they don’t receive it! Around 1-1.4% of the pension pot is typically deducted for ‘commission’, whether there is an adviser to be paid or not. My suggestion, therefore, is that everyone should actually get some advice at the point of purchase. This advice would help people to select the best type of annuity for them and also help them find the top rates in the market for this type of annuity.
For this to be a possibility, the FSA would need to change some of its regulations. Firstly, polarisation issues would need to be dealt with, to allow providers to offer annuities from other companies, if their own are not competitive. It is well known that companies often do not want to write annuities business and, therefore, drop their rates to discourage people from buying. But, due to inertia and also to the practical difficulties of taking an annuity from a different company (form-filling, regulations and so on) many people just buy the annuity they are offered by the seeding company, without ensuring the rate is competitive. Secondly, the FSA would need to approve the concept of two-tier advice – a basic level of advice, which would simply involve people answering the 6 – 10 basic questions that need to be considered for the annuity purchase – without doing a full fact find. These questions would include consideration of age, gender, dependants, health status, guarantee period, need for escalation, desired level of expenditure, other sources of income. If the person’s circumstances were simple (many people buying an annuity have no other sources of income apart from the state pension and would not be in a position to consider investment-linked annuities) this would be enough to select the right kind of annuity. If a person’s circumstances were more complex, they would be advised that they need a different level of advice. The advice would be a hand-holding exercise, to ensure that people have understood what questions they need to consider. For example, many people do not know that they can buy an annuity for live-in partners or disabled children, they do not understand the concept of capital guarantees, of escalation or the importance of considering whether they would be eligible for enhanced rates or impaired life products. This independent financial advice would be given by someone who know about annuities and is not designed to replace the very useful information and help given by organisations such as the FSA. In fact, if the FSA were to design a decision tree for annuities this would make the advice process easier, quicker and cheaper. If everyone received the basic questions with their pre-retirement information, they would be able to think about them before speaking to the adviser. But, decision trees on their own are not enough. People buying annuities cannot be left to understand the issues by themselves. They need someone to talk them through the relevant points, before making this irreversible decision.
The whole advice process should not take too long – perhaps 1 or 2 hours – and could even be done over the phone. It could be made even easier by requiring standard forms and wording (in plain English) from providers when writing to prospective retirees with their options.
Once the appropriate type of annuity was chosen, the adviser would need to check on the various Annuities Exchanges to find the top rates for the desired product. The person would then be able to choose to take one of, say, the top 3 or top 5 rates. The seeding provider would need to have a form signed by an adviser, to satisfy the requirement to ensure that the person buying the annuity had received the basic advice.
If, for whatever reason, the person refused to take advice, they would need to sign a form to this effect. The default, in this case, would be to offer the person a ‘standard’ type of annuity (presumably single life, 5 year guarantee, monthly) but to ensure that this is offered at one of the top rates available in the market, not at the providers own rate, which might be very uncompetitive.
I order to make this work, a reliable source of comparative annuity pricing data would be invaluable. The industry is working on setting up a reliable ‘Annuities Exchange’ and this could be up and running later this year. Even if this does not happen, IFA’s can already find the top rates in the market, and may just need to make a few phone calls to confirm reliability.
If people are able to get the right annuity and the top rates, they will often be significantly better off for the rest of their – and their dependants’ – lives.
For example, a man aged 60, with a pension pot of £25,000, could buy a pension of around £35 per week from the best provider, buy only around £30 per week from one that is 15% below the best (a common gap). So, by not shopping around, he would lose over £5 per week for the rest of his life. If he lived for another 20 years, he would have lost over £5,000 by not taking the top annuity rate.
Or a woman retiring at 60 with a pension pot of £100,000 could lose £20 per week by not shopping around and, if she live to be 90 – by no means atypical today – she would lose a total of £31,200.
The second big change I am suggesting would potentially benefit everyone who buys an annuity, including those with very large capital sums. One of the biggest complaints by people have about annuities is that, if they die early, the money from the pension pot is lost. A number of providers, however, are keen to offer a ‘money-back guarantee’ such that, on death, if the annuity payments have been less than the amount invested, the balance is paid to the person’s heirs. Currently, capital protection is only permitted for up to 10 years and it also has to be paid as income, so that the estate cannot be wound up until the end of the 10 years. I suggest the rules should permit the balance to be paid out as a capital sum and should be taxed before passing into the estate (and then not be counted for inheritance tax purpose, to avoid double taxation). The Revenue would then get its tax sooner and the estate could be wound up promptly.
The cost of this capital protection is not high and estimates from providers suggest that it would cost 0.3% at age 50, 1.7% at age 60, 8.2% at age 70 and 15.7% at age 75. This would be an option that people could choose to take and would allay so many people’s fears about buying an annuity, because the death benefits issue would be addressed.