Response to ‘Modernising Annuities’ Consultation Document
by Dr. Ros Altmann
(All material on this page is subject to copyright and must not be reproduced without the author’s permission.)
Annuities are a special case, among financial products. They are the only financial product which a person has to buy – you are legally obliged to buy an annuity by age 75 with your “defined contribution” pension pot – and they are the only financial product which you are locked into for the rest of your life, once bought, you can never change it.
The element of compulsion and the pensioner’s inability to change investment providers impose an obligation on both Government and the pensions industry to make sure that people approaching retirement make the right kind of decision and get the best value they can.
At the moment, this is not happening:
people do not understand the workings of annuities and often buy the wrong type for their circumstances
people do not know how to make sure they get the best rate for their chosen annuity
people frequently do not realise that saving for a pension is a completely separate decision from choosing an annuity and they may well need to take their annuity from a different company, in order to get the best rates available
the people who fare worst in this market tend to be the less well-off – those with smaller pension pots – who do not get any advice or help about how to make this important and irreversible decision and who often tend to die younger. Middle Britain too is not as well served as it could be from the way the annuity market currently works.
I would like to see the reforms to annuities benefit as many people as possible and to restore public confidence in annuities. Many people have been campaigning long and hard to get rid of annuitisation, either fully or partially, but we believe their proposals would only really help the highest income groups and, for most people, annuities are still the best way to ensure lifelong income in retirement. But they must be made to work better.
Response to questions:
The consultation document asks a number of questions and I will answer the following:
p.33 ‘Are there any further steps that could be taken to encourage people to use the open market option?’
Yes, they could receive advice (preferably independent financial advice) BEFORE they make this irreversible decision. This would be ‘assistance’ in going through the important factors that need to be considered by everyone who is choosing which annuity to buy. It would be a ‘hand-holding’ exercise, for someone who understands the issues to go through the right questions with the person, before they buy.
Decision trees, standard wording on OMO information, simplification of the procedure for actually taking OMO (which is currently a time-consuming and difficult task) would all help the advice process, to make it cheaper and quicker. But people definitely need help before making the annuity choice. Decision trees, on their own, are certainly not sufficient to ensure people will get the right type of annuity.
p.33 ‘Would it be possible for providers to encourage people with funds of all sizes, including the smallest, to shop around for the best rates?’
A requirement for the providers to ensure that everyone has had help (preferably advice) before buying, from someone familiar with the workings of annuities, would ensure that even those with the smallest capital sums can shop around. The help or advice should include finding the best rates available for the chosen type of annuity.
p.33 ‘Are there other ways in which people buying annuities could be helped to find appropriate advice?’
The most direct and reliable way of ensuring people buying annuities get appropriate advice is to require them to take it! If all providers have to ensure that people who buy an annuity have considered the necessary basic questions before buying, this will mean less people will get the wrong type of annuity, more people will get the best value from their chosen annuity and there will generally be less need to consider switching to a different provider, because they will probably have bought the right kind of annuity at a good rate in the first place! Requiring everyone to receive appropriate advice (which could be called ‘annuity assistance’, if the idea of a basic level of independent financial advice is not acceptable) would help significant numbers of people have a higher income to live on for the rest of their lives, at no cost to the government.
p.35 ‘Are there any other ways in which the Government could make delivery of specific advice on annuities more accessible?’
By requiring the annuity providers or pension providers to ensure everyone has take advice on annuities before buying, the Government will have made the delivery of the advice automatic. If the depolarisation issues can be addressed, this would significantly improve the workings of the annuity market for the vast majority of people who currently do not get the benefit of OMO, or get the right type of annuity.
p.35 ‘How could people buying annuities be made aware whether prices of annuities on offer include the cost of advice?’
Providers should point out to people who buy an annuity that they are paying 1 – 1.4% or even more to an adviser, and that, if they do not have an adviser, the money just goes to the insurance company anyway. If the standard letter from the provider to the prospective retiree about annuity purchase were to state something like the following, people would be rather unlikely to buy without advice!:
‘we will be deducting 1.4% of your pension savings, which equates to £280 (on a £20,000 capital sum). This sum is deducted to pay for advice from someone who can help you decide which type of annuity you should buy and how to find the best rate. It is very important that you have help to decide what type of annuity is best for you and there are some very important questions you need to consider, before buying. These questions are set out on the attached sheet. An adviser will be able to talk you through these questions, which are not always straightforward, and help you find a good rate for your annuity. If you buy the wrong type of annuity, or don’t get a good rate for it, you may never be able to change it for the rest of your life. So make sure you get the help you are paying for, to make the right decision. If you decide not to take advice, you will be charged for it anyway. If you do not know how to get advice, please phone us on …’
p.37 ‘Would there be value in standardising the forms used to describe annuities so that people can readily make comparisons?’
Yes, but is important to standardise the wording and to make sure it is written in plain English. A standard timetable which everyone follows for timing of pre-retirement information and timing of transfer of capital sums would also be of great help.
p.55 ‘Beyond the comparative tables planned by the FSA, are there further steps which could be taken to improve information for consumers?’
An annuities exchange would be useful. The industry already has a number of these, which IFA’s are using all the time and a couple of others are being prepared which should be more comprehensive and reliable than those that currently exist.
p.58 ‘Are there any other insurance options that could be made available without prejudicing the Government’s principles?’
Lifetime capital protection would be of great help to the market. It would address many of the fears of those who currently go into drawdown, because they are afraid of losing their hard-earned savings if they die soon. This would be an option they could choose to take. It would have a small cost, but would be much more cost effective and easier to understand than the current option of taking an annuity and buying separate term assurance. By addressing the death benefits issue in this way, people would have much more confidence in buying an annuity and the perception of the market may change. Currently, people can only buy capital protection for up to 10 years and this must be taken as ongoing income, which means that the person’s estate cannot be wound up until the end of the 10 years. This is very unwieldy and is not popular. If people could receive the balance as a capital sum, the Revenue would get its tax back sooner and the person’s estate could be wound up promptly. I would suggest this sum should be taxed separately, and not as part of the person’s estate.
My Proposals for Annuity Market Reform
I have a number of suggestions for making annuities work better.
1. Everyone to receive independent advice before annuitising:
Since most people do not understand annuities, they need help to get both the right kind of annuity and the best rate. If everyone received advice on how to choose the best type of annuity and help to get the best rate for their chosen annuity, many pensioners would be able to have many pounds per week more to live on for the rest of their lives.
2. Default to a top rate
If they choose not to take advice, then it should be encumbent upon the provider to provide one of the top (say 3 or 5) rates in the market as a default option, rather than just offering their own rate – which might be a poor one – as at present.
3. Standardise wording on annuity documentation, so all quotes can be readily compared and ensure that this standard wording is in plain English and clearly laid out.
4. Lay down a minimum amount of time for people to make their choice before they actually retire. Some providers take far too long to send out quotes of pension values.
5. Raise the commutation limit.
Currently, people can only take a lump sum, instead of an annuity, if the capital sum is so small that it provides about £260 per annum of income. This sum could be raised (providing it was the ONLY pension pot the person had), to overcome some of the problems of advising very small capital sums. It is very uneconomic to annuitise a capital sum less than £5000 and possibly even less than £10,000.
6. Lifetime capital protection should be permitted:
In talking to providers, it seems that it is perfectly possible to offer annuities with a ‘money back guarantee’. One of the big complaints people have about annuities is that they are frightened of the insurance company keeping most of their pension pot if they die young. But providers would be happy to offer the opportunity for people to buy an annuity which would pay into the person’s estate, any money not yet paid out in the form of annuity income once they have died.
7. Reserving requirement constraints and polarisation:
The reason why annuity rates vary so much is often because of the reserving requirements involved in writing annuity business. This was not mentioned at all in the ‘Modernising Annuities’ document, which I found surprising. There are times when insurance companies do not have sufficient reserves to back annuities and, therefore, do not want to write any. They drop their rates to discourage people from buying annuities from them, but, due to inertia, lack of understanding, difficulty of shopping around and polarisation regulations, people still take the poor rates. If providers who did not want to write annuity business (for example due to reserving constraints) were able to offer annuities from another company from time to time, this could help the market function more efficiently.
The current annuity requirements are so complex that many potential new providers are discouraged from entering the market. The plethora of different requirements, such as different escalation rates required for different parts of the annuity, or protected rights requirements for joint life annuity even if the person is single, make the actual calculations of annuity entitlements so difficult. The different possibilities for taking tax free lump sums, depending on when contributions were made and what type of money purchase pension scheme one has, are again a barrier to entry for would-be providers. If there could be true simplification, for example just ONE DC regime for all types of money purchase pension, with the same limits on benefits (and contributions and investment vehicles perhaps), the process of annuitisation would be far easier.
DETAILS OF THE PROPOSALS FOR ANNUITY ADVICE
Making sure that everyone who buys an annuity receives at least a basic level of advice and is sure of getting one of the top rates in the market, would address the following important principles that the Government is trying to achieve as a result of the Consultation Document’s suggestions for reforming annuities. The principles stated are as follows:
a. to increase annuity income ‘The Government is determined that any action should, where possible, increase the level of retirement income … through an annuity’ (p.10)
MAKING SURE EVEYONE GETS ADVICE AND USES OMO WILL IMPROVE ANNUITY INCOME FOR MOST PEOPLE. Currently, two thirds of people do not use OMO.
b. annuities should provide a secure income in retirement (people should not use their pension funds for other purposes than providing secure retirement income)
ADVICE AND OMO WILL ALLOW PEOPLE TO BETTER APPRECIATE ANNUITIES
c. any reform should encourage people to save more for their retirement (improving confidence in annuities, should encourage more people to save in a pension)
UNLESS PERCEPTIONS OF ANNUITIES CHANGE, THERE IS A REAL RISK THAT THE MOVE TO DC PENSION PROVISION WILL MEAN FAR FEWER PEOPLE ACTUALLY PUT MONEY INTO PENSIONS AT ALL.
d. people should understand their annuity options (p.28 ‘people may not find it easy to understand what is available and make a good choice’)
ENSURING THEY GET ADVICE BEFORE THEY BUY SHOULD HELP ACHIEVE THIS.
e. people should make the right choices (p.5 ‘The Government believes that reform is necessary to make the annuities market work better, so that consumers are better informed and enabled to choose annuities that provide good value’)
IF PEOPLE ARE REQUIRED TO GET SOME HELP (OR ADVICE), THEY WILL BE MOST LIKELY TO MAKE THE RIGHT CHOICES. THIS ADVICE WOULD NEED TO BE GIVEN BY SOMEONE FAMILIAR WITH ANNUITIES. THE DECISION IS NOT A SIMPLE ONE FOR MOST PEOPLE, ALTHOUGH IT IS NOT DIFFICULT FOR THOSE WHO ARE DEALING WITH ANNUITIES ALL THE TIME.
f. people should get good value (p. 31 the government believes that it is important that the gains from the reduction in stakeholder charges are not damaged by poor annuity decisions).
IF EVERYONE USES OMO, THEY WILL BE GETTING BETTER VALUE FROM THEIR ANNUITY.
Ensuring everyone receives at least some basic level of advice and help to understand their annuity options and make the right decision for themselves, plus ensuring that they get the top rates available on the market, can significantly increase the level of annuity income and provide a secure, higher and better value pension than is currently the case. My proposals, therefore, help to achieve all the objectives set out above.
1. Advice and best rates:
The average person retiring on a personal pension gets a lower income than they should.
Very often they get the wrong kind of pension, or too low a rate. Here are some examples:
(i) people who are not in good health for their age too often end up with an ordinary annuity, even though their lower life expectancy qualifies them for a higher ‘impaired life’ pension
(ii) most married people are left to decide for themselves whether a spouse’s pension is suitable and, if it is, whether it should be two thirds or half
(iii) common law partners often do not realise what their rights are.
Most people do not get the highest pension on the market – instead they just take an annuity from the company which managed their pension investment. Currently, it is MUCH easier not to take the open market option. To take the providers annuity, the person just needs to fill in a form and send it back. To take OMO, many forms must be completed and many regulations complied with. However, often, the seeding provider’s annuity does not provide the best value. The difference between the top and tenth best rates is often 15% or so, and the lowest rates can be much worse than this. Impaired life annuities are often 30% or so higher than ordinary annuities. Someone who does not shop around may get much less than they should, for the rest of their life. The pension industry describes shopping around as ‘exercising the open market option’ – this is not an industry of phrase makers!
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.
The reason for this situation is that most people approaching retirement do not get independent financial advice. Without advice, the technicalities can seem impenetrable and the forms required for OMO are daunting to the inexperienced layman. So 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. Thus, it is not surprising that the annuity gap is so wide. (This is not because the pension companies are at fault – it is more that independent professional advice has never hitherto been accessible, in practice, to most people.)
That is why I believe that one of the most crucial questions raised in the ‘Modernising Annuities’ document is ‘Are there ways in which everyone buying annuities can be helped to find appropriate advice?’
A woman who retires at 60 today has a life expectancy of over 25 years – longer than she spent in education. Male life expectancy too is steadily improving. Gaining the right sort of pension and the best annuity rate are vital if people are to maintain a good standard of living. It is also their right.
But without independent professional advice, the technicalities and the obscure wording of any pension documents make the best choices hard to discover. This is why most people do not ‘exercise the open market option’ and so miss out on large amounts of income to which they are entitled.
One or two hours of advice would suffice – this could be on the telephone, rather than face to face – according to some leading IFA firms. Not all IFA’s have a cost base or an inclination to advise the average person – but many do, and would be happy to.
Provided the compliance requirements are customised to the needs of the annuity market, it would surely be possible for every man and woman who invests in a personal pension to receive a basic level of independent financial advice when approaching retirement, so as to secure the right pension at a top rate.
In fact, the customer is already charged for advice, even though none is given! (p.35 ‘How could people buying annuities be made aware whether prices of annuities on offer include the cost of advice?’) Typically, the insurance company deducts 1 to 1.4% of the pension pot to pay commission, even if there has been no adviser! And some companies deduct huge amounts for advice which is not independent and does not help to secure the best rate for the annuity in the market. A leading life company recently charge an annuity customer 6.8%, without even giving the best rate. So the question of who pays should not be too difficult – the customer pays already. He or she just doesn’t currently receive the advice for which they are being charged!
2. If the industry were unable to provide universal independent advice, a fail-safe for the customer would be to require the company providing the pension to default to one of the best rates in the open market, rather than to the investment provider’s own annuity, as at present.
By thus removing the inertia advantage which benefits low-rate providers, competition could be encouraged and the wide range of prices in the annuities market might be narrowed. But, of course, advice would be preferable, both on the type of pension best suited to each individual and on the best rate in the market.
3. In order to be able to find the best rates, it would be useful to have an ‘Annuities Exchange’ on which all providers would be obliged to post their rates, if they want to offer annuities. The rates could be changed daily, if desired.
This type of service is already used by IFA’s, but is not available to everyone. Some websites and teletext offer comparative annuity rates more generally. The Annuities Exchanges that currently exist are not completely reliable, but tend to work fine in over 90% of cases. We have spoken to some of the major annuity providers and they are keen to set up a proper annuities exchange, which would be reliable and might even be real time and dealable. This is further in the future, but we believe it is quite possible for people to find the top rates in the marketplace by using the existing services, with some telephone checks to confirm the rates if required.
Relevant quotes from ‘Modernising Annuities’ document:
The following quotes from the document all tend to support the idea of ensuring that everyone gets advice or proper assistance before buying their annuities.
p.5 ‘the options discussed in this document are designed to help all pension savers achieve better value and make suitable choices when they use annuities to turn their pension savings into retirement income’
p.6 ‘this document contains options to increase general understanding of annuities and ways to enable individuals to obtain the information and advice they need to make well-informed and appropriate decisions’
p.28 ‘people may not find it easy to understand what is available and make a good choice’
p.28 ‘buying the wrong sort of annuity usually means a commitment for the whole of the pensioner’s retirement and so can have serious consequences even if, in its own terms, the product chosen offers a competitive rate’
p.35 ‘most people should turn to an authorised financial services firm for advice specific to their own circumstances and needs when selecting their annuity’.’
p.35 ‘how can people recognise good value annuities on good terms?’
p.36 ‘help customers appreciate how advice is paid for, whether or not it is actually taken up’
DETAILS ON LIFETIME CAPITAL GUARANTEE
Offering a lifetime capital guarantee
One of the biggest complaints people have about annuities is that, if they die early, the money from their pension pot is lost. A number of providers, however, are keen to offer a guarantee of return of any capital not yet paid out, if the person dies before his or her pension income has equalled the capital value of the pension pot.
The cost of capital protection is not high and estimates from providers suggest it would cost about 0.3% of the annuity income at age 50, around 2% at age 60, about 5% at age 65, about 8 % at age 70 and around 15% at age 75.
Providers are perfectly happy to offer this type of product and it would be very useful as an extra type of provision in the annuity market, to counter the objections of those who are afraid to or resent annuitising, in case they get very little back if they die prematurely. I believe this should be paid as a lum sum, rather than as income. The Government would get its tax back sooner and the person’s estate could be wound up promptly.