Are annuities fit for purpose?

2 February 2014

by Dr. Ros Altmann

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Last week, there was an important debate in the House of Lords, organised by Baroness Sally Greengross, head of ILC-UK, sponsored by Legal and General and attended by annuity providers, brokers, advisers and consumer groups.  The topic was ‘Are Annuities fit for Purpose?’

On the panel were Tim Gosden and Kerrigan Proctor of Legal and General, Dan Hyde from the Daily Telegraph, Sue Lewis of the Financial Services Consumer Panel, Tom McPhail of Hargreaves Lansdown, Jane Vass from Age UK and me.  The following is a summary of my views and you can link to my presentation slides and transcript of my full remarks here http://bit.ly/1fNwzaO .

Summary: 

• If customers are buying annuities without any advice, without suitability checks and without having to provide relevant information, we have no idea whether the annuity they buy is fit for purpose. 
• The FCA has failed to protect annuity customers. 
• They are regulated as a ‘no risk’ product that is suitable for all who buy them and there are no controls on value for money or fees and charges.

The purpose of annuities is to help pension savings meet retirement income needs but the market is not working well for customers:  The problems are not just about whether annuities offer good value at today’s low rates, but include a sales process with hidden fees and charges paid by unwitting consumers and failure of providers to ensure those buying standard annuities get suitability checks or advice before buying.

Annuities are supposed to meet retirement income needs but rates have fallen sharply: Annuity rates dropped sharply to around 5% in 2012.  They have now recovered from their lows, but the hundreds of thousands of people who bought last year will be permanently poorer because they cannot undo the deal.  In the past, annuity rates were much higher and offered better value but even the best annuity providers were paying very poor annuity rates a year ago.

Annuities are being sold as a ‘no risk’ product which is suitable for everyone: The FCA has absolutely failed to protect pension savers in this market.  It has consistently left it to the ABI to self-regulate.  As the excellent report from the Financial Services Consumer Panel recently highlighted, this is not working and urgent changes are needed to make the market operate more fairly for customers.  This is despite the fact that annuities are a unique financial product because they are both complex and irreversible. If a better product comes along in future, you will never be able to buy it if your pension savings have been spent on an annuity.

Nobody needs to give customers risk warnings or make suitability checks, it’s just caveat emptor, even though this purchase is irreversible:  Many of those who buy an ordinary annuity are in poor health and could have received a much better rate if they had used an advice or guidance service.  This cannot be ‘treating customers fairly’ but there are no safeguards to prevent such sales.

As retirement becomes longer and starts later, one-size-fits-all does not fit all any more:  When retirement was expected to last five or ten years, and started for everyone at a uniform age, such as 60 or 65, buying an annuity was more suitable, but as retirement has changed significantly, with people both working later and living longer, the one-size-fits-all annuity product is not really fit for all at all.  It is just too much of a lottery.

Annuities insure against ‘living too long’ but there are other risks that they won’t help with:  The major attraction of annuities is that they will continue to pay you however long you live – a kind of insurance against living ‘too long’. But people will face many other risks during their later years.  Standard, single life, level annuities offer the highest starting income so they are most often bought, but will not protect against inflation (after 25 or 30 years the income will probably be worth much less) and there is no provision for partners or dependents.  I estimate that future widows could lose out on £1billion a year of income from their husband’s pension savings as a result of purchasing a ‘single life’ annuity instead of ‘joint life’ because they thought shopping around for the ‘best rate’ was the right thing to do.  Therefore, standard annuities have no flexibility to adapt if health or market circumstances change, so they will not necessarily suitable for everyone.

Ensuring everyone shops around using their OMO is not an answer:  The FCA has relied on the open market option (OMO) to drive better outcomes, but this is not the answer.  It often leaves people bewildered, or leads them to just shop around for a better rate, but for the wrong product!  Getting the best rate for a standard annuity is not good enough.  People need firstly to decide whether doing nothing or taking the fund as cash, would be a better option, but they often believe they actually have to buy an annuity even if they do not need to.

There are no requirements for suitability checks, risk warnings or controls on fees and charges:  Firms can sell customers an annuity without any risk warnings or suitability checks and there are no controls on the charges, rates or value for money offered by annuities.  Firms can charge what they like and price the annuities as uncompetitively as they wish.

Hidden fees and charges have biased market against advice:  Following the RDR, brokers, pension providers and non-advice services are still allowed to charge commission for selling annuities without any advice, which need not to be properly disclosed until the point of sale, whereas IFAs have to agree a fee at the beginning of their engagement with the customer for at retirement advice.  This puts people off taking advice and has biased the market against the advice people really need before making this irreversible purchase.  Indeed, there are no controls on the amount of commission charged, with the FSCP having found some charge over 5% of the pension fund, and this means buying without advice can be more expensive than using an IFA.  Many IFAs will charge a fixed fee, such as £750 or so, which is actually less than the 3.5% commission on a £30,000 pension fund which amounts to £1,050 with no individual advice or regulatory protection to ensure they are doing the right thing.  This is a direct result of well-meaning reforms that were supposed to protect the customer!

So what reforms of the annuity market could help make it fit for purpose? As this transaction is irreversible, customers need advice and protection before purchasing.  Annuities are not suitable for all. Unlike other insurance or investment products, if you have done the wrong thing, you cannot move to a better firm so it should be mandatory to provide proper information, risk warnings and preferably some advice before people buy.  The following reforms are required:

• Do not allow anyone to charge commission for selling annuities
• Introduce proper controls on fess and charges
• Stop bad value products being sold
• Require risk warnings and suitability checks before sale
• Encourage advice
• Reform of the Treasury’s Conduct of Business rules, COBS19.4:  Currently, annuities must be mentioned in the letters sent to customers.  This requirement should be abolished so customers are just given standard information and need to decide whether, when and how to take income from their pension savings.  This would force them to engage with the decision, rather than be left stumbling blindly into buying an annuity which may not be suitable for them.

The industry itself could also do more to look after customers.

• Agree to disclosure of fees and hidden charges
• Introduce ‘know your customer’ checks before selling annuities
• Will some of the insurers who operate to higher standards stand up against poor value instead of the ABI accepting very low rates being offered
• Develop new decumulation options that better fit with people’s lives:  Perhaps some kind of simplified drawdown for smaller funds or for those who don’t want to choose their own investments, rather than buying one irreversible product despite having a 25 or more year time horizon.

So to conclude, when considering whether annuities are fit for purpose, I have three main points:

• If annuities are being bought without any suitability checks or advice we really have no idea whether they are fit for purpose for those buying them now.
• A standard single life level annuity, which is irreversible and inflexible and which people buy at a relatively early stage in their later life is unlikely to be suitable for all.
• High and hidden charges should be banned with no commission being allowed to be taken by anyone selling annuities
• The annuity sales process should not be biased against the advice people need.

As millions more people are auto-enrolled into DC pensions, we MUST reform the way this market is working.