Annuities still have a big role to play – but we need to adapt them to fit today’s world says Nest chief investment officer Mark Fawcett
‘Reports of my death are greatly exaggerated,’ so said Mark Twain. The same could currently be said about annuities, which are subject to a similar narrative.
Of course there are plenty of reasons why we might mistakenly hear the ring of change for annuities as their death knell. But if we look beyond the product and consider some of its core features, it’s clear that the end may not be nigh after all.
Last year’s radical reforms to how people can access their pension pots and December’s FCA report into historical problems in the annuities market have been perceived as the final nails in the coffin for annuities. But this view ignores what people prize so highly in their lives and, particularly in later life – certainty and security.
Our research tells us that what’s important to consumers when they’re taking their money out of a pension scheme isn’t very different to what’s important to them while they save – there’s a strong desire to protect against volatility and loss and an appetite for a predictable outcome.
Research shows that when asked what are the most important aspects of a retirement product, consumers put a guaranteed income until death in their top three priorities, alongside protection from inflation and from market risks.
Perhaps paradoxically, it is also the widespread aversion to loss and fear of making decisions they may later regret, that makes people so reticent about buying an annuity.
To buy an annuity in their current form is to give up control of what happens to your money. In this mix, annuities sit uncomfortably with the common desires to both leave as much as possible to loved ones and the flexibility to use some of the capital for life’s emergencies.
While the new pension freedoms from April mean savers no longer have to buy annuities, it should not necessarily mean that we’ll see an entirely drawndown-dominated landscape. This is because we know many savers do not understand what effect investment losses might have on their retirement. In addition, they’re also liable to be conservative when it comes to how long they expect to live and are also unlikely to be risk-seeking at a time typically associated with financial prudence.
As such, buying a guaranteed income for life – at some point – may hold significant value for some people. Also, the mortality drag effect means that at a certain age – although likely to be later than most people’s normal retirement age – annuities offer the best deal in town in terms of turning a chunk of capital into a sustainable income for life.
The traditional binary debate between annuities and drawdown may be no longer relevant. We have a once-in-a-generation opportunity to look at how elements of each might be used to create more flexible solutions that work for the majority of DC-dependent savers long into the future.
In Australia, annuities are now being written that give proportions of capital back in the early years in case of death. Such arrangements look to satisfy the desire to leave an inheritance – doubtless you’ll have seen this as a strong emotional driver among many of your clients in your retirement planning conversations.
In the US, scheme guidance has evolved to allow for different ways to integrate the benefits of deferred annuities into people’s pension planning.
So there is scope for innovation, for example, by paying money as a series of ‘long life insurance premiums’ through time rather than one large lump sum. Savers might buy chunks of deferred annuity units with their pension contributions as they approach retirement. This allows them to put in place some guaranteed income for life. It also offers them an opportunity to jump the psychological barriers of both handing their money over all in one go and taking their chances with the one-off annuity purchase lottery because they’re spreading their buying of annuities at different rates over time. Unfortunately at the moment, a fully functioning deferred annuity market does not exist in the UK currently, not least because of issues of capital constraints at insurance companies. The retirement market is approaching an unprecedented era with millions of people being brought into DC pension saving at a time when they’ll rely ever more heavily on those savings.
Having opened up the options at retirement there is now an opportunity to develop solutions that could affect the lives of millions of people in old age for the better. Advisers will be well-placed to help people make the most of their retirement savings in innovative ways.