FOOL'S EYE VIEW
Modernising Annuities

By James Carlisle
February 8, 2002

Fulham -- The Government has produced a consultation document that looks at ways of improving the ways that we generate income from pension funds. The title of the document, 'Modernising Annuities', gives it away. The Government wants suggestions as to how the current regime on annuities can be improved, but there's no intention to get rid of the requirement to use the bulk of your pension fund to buy one.

The only thought given to alternative regimes is in the four page Chapter 6 (it's a 66 page document). Even then, there doesn't appear to be much consultation being sought on the subject. Instead it's just the Government saying why it's going to stick to annuities.

One of the core planks in the Government's reasoning is the complex issue of 'mortality drag'. Briefly, this is an effect whereby the older you get, you have to make an increasingly good investment return outside of an annuity to justify not buying one. This is because, while others die, you lose out on the 'cross-subsidy' that their annuities would provide you. It seems to me that this argument has a flaw, being a literal manifestation of 'survivorship bias'. You have to wonder about those that die young and end up doing the 'cross-subsidising' of those that die later.

Anyway, if we leave aside the debate about compulsory annuity purchase, and settle for the fact that annuities are with us at least for the time being, then there are some good points in the document.

Education

First up, the Financial Services Authority will soon be extending its consumer education programme to cover annuities. The report also notes that 80% of annuities bought are of the 'flat' variety that don't increase with inflation. That looks high and suggests that people don't fully understand the benefits of inflation protection. So the document asks for help in finding ways to encourage people to look at the various alternatives. One possibility that it suggests is for more help to be given in the work place, through employers, trade unions and 'others'.

Value for money

The 'open market option', which means people can opt to buy their annuity from any provider is hampered by the fact that some annuity providers set a minimum size of fund that they'll consider for 'open market business'. This means that competition is reduced for people with smaller funds. It's a tricky problem, because commercial realities dictate that the smaller funds are less profitable for the providers (or not even profitable at all). Even so, it's a positive step for the Government to be asking for help in finding a solution.

One suggestion is that the CAT standard regime, by which products are given the CAT label if they meet minimum criteria on Charges, Access and Terms, be extended to annuities. Because annuities, as an insurance product, require a provider to make a subjective assessment of risk, it's hard to see how this would work, but it may be possible to give annuities different labels according to whom they might suit.

The consultation document also wants to explore ways that 'transfers' between different providers could help the annuity market. Rather like you can 'remortgage' your house, you could go and 're-annuitise' your pension fund. Essentially it would only make sense to switch if you could get a better annuity rate, for instance if your life expectancy had reduced. The trouble with this is that the annuity provider can't reduce your rate if your life expectancy increases. In other words, this sort of flexibility doesn't really work in the world of insurance. Still, they're asking the question.

Simplification

This is the big one, in my opinion. Report after report (including from the Institute For Fiscal Studies yesterday) shows that we need to be saving more for our retirements, yet we have a pension system that must be putting people off simply because of its complexity. Anyway, the report states that:

The Government recognises that the complexity of the current tax treatment of pensions can be a barrier to helping people understand their pension investments and choices. The rules about pensions have developed through successive reforms and improvements. While each could be justified in its own terms, together they add up to a complicated set of rules about what can be saved and how. There are parallel exercises taking place at the Department for Work and Pensions and at the Inland Revenue to consider whether there is a case for simplifying the rules that apply to pensions.

Three cheers for that!

Innovation

The Government wants to see more innovative and flexible annuity products. That way there should be greater competition and consumer choice. There are a couple of things counting against this at the moment. First of all, new entrants to a market are often the most innovative, but it's too difficult for new annuity providers to break into the market because the established players, with their experience of life expectancies and other risks, are in a much better position to get the pricing right. So the idea is to find ways of encouraging new providers into the market.

The second difficulty is that the rules on what annuities have to achieve are more than a little vague. The relevant rule states that 'they should deliver a secure and sufficient income for life in return for the pensioner surrendering saved pension capital, and are not a tax favoured method of saving for other purposes'. The annuity providers maintain that it's hard to innovate when you don't have much of an idea about what would and would not be allowed.

Unfortunately, the Government appears to think that it would stifle innovation to have detailed rules and, instead, they want to introduce a regime where people just come to them to see if it's ok and receive a tick. That strikes me as a cop out. The free market is going to be better at working out what the Government does want, but the Government at least needs to be clear on what it doesn't want. Otherwise we're no further forward from the current situation.

Some good and some bad, then

It's a shame that the opportunity has been missed to consult properly on possible alternatives to annuities. To me that's where the more interesting debate lies. But if we're stuck with them, then the Government is at least taking some steps to improve the way they operate. If it could find a way to simplify the entire world of pensions at the same time, then that would be marvellous.

Pension Centre