Can we make the annuity market work?
People who save in a Defined Contribution pension scheme build up a savings pot while they are working and contributing. When they retire they need to turn their savings into pension income. Most do so by buying an annuity from an insurance company. An annuity is a promise to pay a steady income until death. But most agree that the annuity system is not working.
The Financial Conduct Authority’s damning report on annuities is only the latest in a series. The NAPF and the Financial Services Consumer Panel have already produced similar indictments. The concern is nothing new. The previous government compelled pension providers to inform their savers of what is called the open market option in 2002.
Few disagree that something needs doing, but my worry is that too many think the solution is to build a competitive market that will automatically deliver best outcomes for consumers. This is the kind of approach that we labelled second consensus thinking in the Touchstone extra Third Time Lucky. Auto-enrolment was introduced because second consensus thinking did not deliver. The talk of charge caps and minimum standards is evidence that we need further change. We now need to rethink the decumulation phase (when people turn their savings back into income) as well.
But first a bit more about how annuities work. The difficulty with turning a savings pot into pension income is that you do not know how long you will live. If you live a long time, the risk is that you take too much income too soon and run out. The state is not too keen on this as you would then need to claim benefits. This is why most people are compelled to buy an annuity.
Annuities therefore pool longevity risk. Those unlucky enough to live for a short time get less, centenarians do very well. You can also think of an annuity as a way of insuring yourself against the risk of living longer than expected.
Annuities provide a guaranteed income. The guarantees come in different flavours. The simplest and most popular annuity pays out the same cash amount each year until the policy holder dies. But you can also choose an annuity that is linked to inflation so you start with a smaller amount but it maintains its purchasing power. You can also have a joint life annuity so that if your spouse/partner outlives you then they continue to get an annuity. Again this will pay out less at first than a single life policy.
People who smoke or who have other health issues that are likely to shorten their lives can get enhanced annuity rates. Insurers will also take your postcode into account. If you live in a declining industrial area, you will do better than if you live in a leafy suburb or country town. There are other variations such as policies that will pay something back to your estate if you die shortly after buying the annuity.
There are also ways that you can take money from your pension pot without buying an annuity. Everyone is entitled to take some of their pension as a tax-free cash lump sum. If you have only a very small pension pot then you can take it all as cash – this is known, in what I think of as one of the worst bits of pension jargon, as trivial commutation. You can also take money directly from your pension pot as what is called income drawdown.
You might expect a market in annuities to work better than one in the saving part of pensions. If you are 30 and choosing a pension scheme to save into for decades to come, there is little that most people can understand that allows them to tell the difference between products. But when you buy an annuity it is much easier to compare products. If you have £50,000 then you can see how much each company will give in pension income from your pot.
But the market does not work. Too many take an annuity from the pensions company they saved with – even when they point to the open market option – the right to take your pension pot to any annuity provider. The complications of the annuity market mean that many people say that everyone should take professional advice before taking an annuity. But professional advice is inevitably expensive, and with increasing numbers building up small pension pots as auto-enrolment starts, many would take a big chunk out of their pots to get advice. Many people in any case do not trust the financial services sector with its legacy of commission driven advice and mis-selling.
If you only have a hammer, then your only solution is hitting everything. There are too many people around who see market competition as the only solution to every problem. Yet this did not work to encourage people to build up pensions. Behavioural economics tell us that real people do not act in the way that simple economics text books predict. Indeed many of its insights have been gained by watching how people deal with pensions and investment.
The same people who talk up markets in this way also stress the importance of choice – even though real people find too much choice paralysing when making big decisions. DB schemes provide no choice. Nearly always you get a dual life partially-indexed pension.
This is why those who say we should provide a default option for DC pension pots where some kind of national broking service automatically get people the best deal for a simple annuity product are on the right lines.
Instead of millions of uncertain individual customers getting confused in a market they do not understand – an expert broking service that did understand the market and was able to drive a hard bargain with insurers would act on their behalf, just as in well run trust-based pensions the scheme acts in the interest of members and no-one else.
But even this approach is based on the traditional annuity. The advantage of an annuity is that it guarantees some kind of steady income, but this is also its disadvantage. Guarantees are expensive. A 65 year old gets a little over £6,000 a year for a £100,000 pot – not a lot for your pot many would think.
Investment returns depend on taking risk. Because things might go wrong and you don’t know what you will get back, you expect to get a return above what you would get from putting the cash in the bank. Guarantees over many years are very expensive. (This is why the TUC was not very keen on building guarantees into the accumulation phase – one option in the defined ambition debate).
This is why Collective Defined Contribution schemes that provide pension income that is not guaranteed but has a very, very good chance of doing better than an annuity are attractive. See here for more about CDCs
Steve Webb is right to change the law to allow them in this country. And perhaps it is the threat to annuities that helps explain the ABIs opposition to CDC (as well as their opposition to unions playing a role in pensions.)
UPDATE: Here are two must read blogs from pensions insider, Henry Tapper, on annuities:
- A slightly techie argument using figures from the Government Actuary’s Department to show that annuities are inefficient.
- Using his insider knowledge and keen sense of pensions history, Henry argues the superiority of CDC to individual annuities.