Annuities brefing January 2014

by Dr. Ros Altmann

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ANNUITIES:

Here is a background briefing:

Annuities are a unique financial product. There is no other investment or insurance you can purchase which, once bought, can never be changed. If you buy the wrong house, you can change it. If you take out a poor value mortgage, you can change it. But if you buy the wrong type of annuity or buy at the wrong time, you are stuck.

An annuity is a complicated product which puts a workers’ entire pension fund capital at risk. Buying the wrong type of annuity often leaves widows or widowers with nothing from their partner’s hard-earning pension savings. And yet nobody has to provide any risk warnings to customers before they make this irreversible purchase. Pension companies can sell you an annuity without even asking the most basic questions that would help identify whether a standard annuity is actually unsuitable for you. This is a product that most people only buy once in their lifetime, therefore they have no experience of how to do this right. The asymmetry of knowledge, information and power leaves consumers at a huge disadvantage relative to those who provide or sell annuities to these poorly-informed customers who do not know how to find the right kind of annuity. Nevertheless, there are no proper safeguards to ensure customers are actually treated fairly. Nobody has to make sure customers get good value for money and a top rate, providers are not obliged to make ‘know your customer’ or suitability checks. The industry has been left to self-regulate for many years. That leaves customers out of pocket while pension and broking firms make significant profits, with no regulatory protection for most buyers. The FCA regulation of annuities allows annuity providers to charge what they like by way of costs. There are no controls on the value for money offered to individuals. One has to ask who is looking after the customer when there are no safeguards in this market.

How are annuities supposed to work? Annuities are meant to work as follows: Workers give their pension fund to an insurance company and the insurer promises to pay them a small part of their fund back each month. If they are still alive once all the fund has been paid back to them, the insurer will keep on paying the promised amount until they die. The principle on which annuities are supposed to work is that the insurance company uses money left over from pension funds of those who die before their fund has run out, to keep paying to those who outlive their fund. In this way, annuities are meant to be a type of insurance, with those dying early subsidising payments to those who live longer than expected. This ‘mortality cross-subsidy’ is supposed to be built into the pricing of annuities. Annuities are supposed to give peace of mind, to protect people against the risk of outliving their pension savings.

What is wrong with annuities? A standard annuity is a single life, level annuity. This pays a specific level of income, the same every month for the rest of the person’s life, but does not cover a partner and has no inflation protection. This type of annuity is the one which generally offers the ‘best rate’ and is the one most people buy. Emphasis on ‘shopping around’ and using the open market option to find better rates will drive customers to buy this type of product, even though it is not necessarily appropriate for them. When they use an annuity broker or non-advice service, they believe they should find the best rate, but these standard annuities are not sufficient for managing the risks that people face in retirement. The main risk that annuities could help with is the ‘risk’ of living a long time. But there are many other risks that annuities will not cover:

• The risk of dying young
• The risk of inflation (even if the income is paid out till you are in your 90s the value of the money received will be much less in real terms
• The risk of becoming ill
• The risk of leaving a partner with nothing from your pension savings
• The risk of needing money to pay for long-term care
• The risk that interest rates may rise and annuity rates will improve
• The risk that investment markets will do well, but your pension fund will never benefit from better returns in future

How can we assess the value of annuities? There have been numerous academic studies of annuity value. The most recent include Cannon and Tonks who published a paper in 2012 which suggested that annuities were not bad value, even though annuity value for money has declined over the past few years. There are several problems with this analysis. Firstly, the data used only go up to 2009. Since 2009, annuity rates have fallen substantially. Secondly, the data used are only those published for the open market, whereas most annuities bought are from an existing pension provider, so the annuity rates most people buy at are worse than those used in this study. But, thirdly, the value of the annuity is assessed relative to receiving back the original pension fund, without including any interest or investment returns on the fund. Of course, insurers earn returns on the funds and the individual could earn money on their pension fund too. The academic studies suggest that annuities return about 84% of the original fund value on average. Since then, annuity rates have worsened, and recent rates are even poorer value.

Annuity rates too low now: Indeed, annuities have now become very poor value. The insurance against living too long is now priced so highly that most annuity purchasers are unlikely to get the benefit of the mortality cross subsidy. And people face many other risks during their retirement which an annuity will not cover them against. So their entire pension savings are being devoted to protecting against only one of the risks they face, while they have no protection or insurance against all the other risks. The trouble is that people do not understand what is happening. Having saved for so long to build up a pension fund, they would surely hope it could protect and provide for them adequately in retirement, but this is not happening as annuity rates have fallen so far. The annuities market is a scandal in the making, with uninformed, unprotected customers having significant sums of money taken from them when buying annuity products which will often give them the wrong product at poor rates with high charges as well. More than one thousand people every day (over 400,000 a year) are buying an annuity, yet annuities have become such poor value in many cases that insurance companies may be mis-selling them – just like PPI was mis-sold by banks. This market is worth around £15billion a year.

How does the process of buying an annuity work? When starting a Defined Contribution pension scheme (such as personal pensions, group personal pensions, stakeholder pensions and most auto-enrolment schemes) the worker is usually asked to select a retirement date. That will often have been either age 60 or 65. The worker then puts money in each month, which is invested in a fund that builds up over time. Most people do not want to choose their own investments, so for those who would rather leave the investment decisions to the fund managers, pension companies provide a ‘default fund’. These default funds often have investment profiles that are geared to buying an annuity at the pre-set retirement date. The funds will invest workers’ money in equities in the early years and then switch into bonds in the years running up to the originally selected date. The fund is switched into bonds in order to reduce the risk of capital loss close to retirement and also to prepare for annuity purchase (because annuity prices tend to be linked to movements in 15-year gilt yields). On reaching the previously chosen retirement date, the pension company will contact the worker and explain that he or she needs to turn their pension fund into an income. The pension company will often explain that workers can buy an annuity from them (or a chosen affiliated insurance company) and this will pay them a ‘secure’ income for life. Under the new ABI code, the worker may not be sent a form on which they can just tick a box and send it back to their pension company in order to buy the annuity they have been offered. Instead, the new ABI code requires the pension company (if they belong to the ABI) to write to the customer, tell them they can buy an annuity from their pension provider or they can also shop around to find an annuity with a different company. The pension provider is not obliged to tell them that they don’t actually haveto buy an annuity, or any other product. They could simply leave the money alone and continue to invest it to earn more returns.

Is ensuring people take the open market option enough? Workers must be told that they have a right to an ‘open market option’ which means they can shop around for a better rate elsewhere (of course many people simply do not understand what this means and they are not told of the option of not actually annuitizing, so they generally believe that is what they have to do). The FCA seems to believe that just telling customers about ‘shopping around’ is enough to ensure companies are treating customers fairly. TCF is about far more than this. Just making shopping around mandatory for all those reaching pension age may help them get a better rate for the wrong product, but will not ensure they get the best rate for the right product, or help them understand they don’t need to buy any product at all! Most people will usually have no idea what an annuity is, how to assess whether they are being offered good value for their money, or indeed whether they are being offered the right product at all. What they are often told is that they should try to find a better rate using their ‘open market option’. This misleads people into believing that finding the best rate is the most important element of the annuity decision – to give themselves the highest starting level of income they can find. However, just finding the best rate may not actually be the most important factor.

Why focussing only on telling people about the open market option is not good enough:

The focus on finding the best rate is not the most important issue for people to consider. There are three steps that need to be addressed first. Getting the best rate is the fourth decision.

Pension fund income decision process for the modern world:

1. Timing– Do I need an income at all?
2. Product– If I do need an income, what is the best way to take it (trivial commutation? Other products?)
3. Type of annuity– If annuity is best, what type of annuity product do I need?

Then, and only then…

4. Rate– How do I shop around for the best rate for the type of annuity that I need?

Firstly, it is important to decide whether buying a pension income as an annuity, or as another product, is the right thing for the worker to do at that point in time. If they are still working or have other pensions, they might benefit from waiting and leaving their fund to earn investment returns. Secondly, if they do need more income straight away, what is the best way to achieve that. This could be with a guaranteed annuity, or it could be with other types of product. Thirdly, if an annuity is considered most appropriate, it is important to find the right kind of annuity. There are many different types. Only after that, will the customer be ready to shop around and find the best rate. Thus, emphasising ‘shopping around for the best rate’ will not ensure steps 1, 2 and 3 have been properly addressed, so workers who do shop around may get better rates for the wrong product or might not actually be best advised to buy a pension income at all at that time, except they will not know this.

Widows at risk of poverty: Searching just for the best rate will often leave widows or widowers with no pension, as the best annuity rate will usually cover only the person buying, not any partner. Therefore those who die relatively early will leave nothing for their dependents, leaving widows at risk of poverty because their husbands did not buy the right annuity. For a small extra amount (in other words, by accepting a slightly lower initial pension income) workers and their dependents could get better total value from their pension savings.

Highest rate means lowest guarantee period – capital at risk: The highest starting income also means the person might not have any guarantee on their annuity payments – or perhaps only have a 5 year guarantee. At a 5% annuity rate, only one quarter of the person’s original fund would be paid out to them (5 years times 5% of their fund = 25% of the fund). The insurance company would keep the other three quarters of their fund and all investment returns on it too.

No inflation protection: People buying a standard annuity have no protection against inflation (inflation linked annuities pay a far lower starting income).

Wrong time to buy: Some people who shop around would be much better not buying an annuity at all at that time, however they will not know that. They are told they need to shop around so they believe they actually have to buy a product. However, if they don’t need the extra income straight away, they may be better waiting to see if their own or if market circumstances change in the next few years. They can either take their 25% tax free cash and live on that for a time, or they may still be working and not need more money immediately.

‘Do nothing for now’ option has tax benefits: If someone has not yet annuitized, their whole fund can pass on tax free if they die before age 75, whereas if they have bought an annuity that they did not really need, or even if they have gone into income drawdown, they will face a 55% tax charge.

What charges and fees are paid when buying annuities? There are no controls on the costs and charges when people buy annuities. Pension companies have captive customers who will often unknowingly have money taken from their pension funds when they buy an annuity. They cannot avoid those charges.

No controls on charges: When buying an annuity, people will always have money taken from their pension fund (generally between 1.5% and 4% of their fund value). They cannot control this, the money is deducted whether they buy through an adviser, use a broker or even if just stay with their current pension provider. The annuity market is not working for customers, it is working for the pension providers, insurance companies and annuity distributors. There is no regulatory control on the charges levied although the Regulator forces IFAs to agree a fee up front, while other sellers such as annuity brokers can take commission out of the pension fund which could even amount to twice as much as a using the independent, whole of market adviser and the customer could be buying the wrong type of annuity, not getting the best rate and has no regulatory protection.

Through what channels can workers buy annuities?

1. Through an independent specialist financial adviser
2. From their existing pension company
3. From an annuity provider that is chosen by their pension provider if their pension company does not sell annuities it can tie up with another firm
4. From an annuity broker or tied sales adviser

Using an independent financial adviser: Using the services of a specialist IFA should be the best way to buy an annuity. The adviser is impartial and their job is to make sure you understand your options and recommend the right choice for you. The IFA can help ascertain whether buying an annuity is the right decision at the moment, then, if so, find the right type of annuity for your circumstances and then check all the providers who are offering annuities at that time to find the best rate. The adviser can fill in the forms, check all the existing pension paperwork and you will be covered by regulatory protection if something is wrong. Advisers can also haggle with insurance companies to obtain better rates. Advisers often do all this for less than the cost of buying direct from a self-service, non-advised broker.

Existing pension company: Buying from the existing pension company, is usually the easiest option and usually the worst value. Pension companies know that they have captive customers and can get away with offering very poor rates. There are no regulatory controls or oversight on the rates that providers are permitted to charge. The existing pension company has powers that can entice customers to stay with them. For example, as they actually hold the pension fund money, they can pay out any tax free cash quickly. This often tempts workers to stay with their existing pension provider. It is important to realise that when buying from your existing pension company, even though the company offers no advice and may pay a very poor rate, the FCA allows the provider to take money from your pension fund, just for selling the product, without any control over the value delivered for this charge. The amount deducted is a proportion of the fund value (often 1.5-2%). This money could be used to pay an adviser’s fee, but if there is no adviser or broker to pay any commission or fee to, the pension provider just helps itself to the money.

A provider tied up with the existing pension company: Some pension companies do not sell annuities, but have tied deals with providers instead. For example, Zurich Life has a deal with Legal and General under which all its pension savers are offered a Legal and General annuity at their pre-selected pension age. When a customer merely takes that annuity, the terms of the deal specify that Legal and General will pay Zurich Life 3.5% of the value of the customer’s pension fund and that 3.5% is reflected in the annuity rate offered. There is nothing the customer can do to stop that money going to Zurich, rather than being used to enhance their pension income. The deal does not help the customer to find the right annuity, does not offer them advice for that money and does not even ensure they get a good rate. There are simply no regulatory controls on the way these charges work, nor on the value delivered to customers. How can such arrangements be in the customers’ best interests.

An annuity broker: If buying through an annuity broker, customers can visit a website with the offer of a ‘free’ service, but when they actually buy from that broker’s site, the broker takes a chunk of the fund as ‘commission’. Annuity brokers will charge customers, but the transaction is not covered by regulatory protection as the sales are ‘non-advised’. So the customer can buy the wrong product and not even get the best rate, can pay commission to the annuity broker and have no protection if things have gone wrong. People in poor health are less likely to obtain best annuity rates when using an on-line broking service than if they see an IFA, because their enhanced rate quotes are based on generic questionnaires which will not necessarily reflect the actual medical or health condition of each person. The amount of commission charged for obtaining enhanced rates is around double that for ordinary annuities (often 3.5% or more of the fund) while using an independent financial adviser will cost less depending on fund size as an IFA can shop around on the basis of each individual workers’ health situation and can even haggle with providers to obtain higher rates.

RDR has biased the market in favour of non-advised brokers and against IFAs: The FCA financial regulator’s recently introduced regulatory changes – (RDR or Retail Distribution Review)) have banned independent advisers from taking commission when selling annuities, but allows non-advised brokers to do so. The IFA must tell clients at the beginning what fee they will charge, while guidance services are allowed to take commission but do not have to tell customers what they will pay until the point of sale. This means that the regulator has biased the annuity market against people receiving independent financial advice that could help them find the right product at a good rate. Indeed, it is often the case that an IFA could provide advice for half the cost of going to a direct-sell service. The non-advised sale has no regulatory protection, will not necessarily ensure people buy the right product and may not even cover all the annuity providers in the market, yet the FCA allows them to charge far more than a fully regulated, independent, whole of market adviser.

Why is it so important to address the problems of annuitisation urgently? As auto-enrolment proceeds, and as most defined contribution pensions may rely on annuity purchase to provide a lifetime pension income, it is more important than ever to ensure workers can achieve the best value from their pension savings. Most people are unaware that they need not actually buy an annuity at a pre-set age when their pension company writes to them. The amount of money pensioners lose by buying the wrong annuity or getting a poor rate can be more than any gains they might make by capping the fees paid when building up their pension fund. Indeed, pension charges have already fallen, with most new schemes having annual management charges of 1% or less, but there has been little meaningful reform of the charges and value for money at the end of the pension saving process. When buying an annuity, people can lose much more than they would lose by paying an extra 0.25% charge each year in ongoing charges. The charges are anywhere between around 1.5% and 4%. The Government’s analysis suggested that a charge cap of 0.5% instead of 0.75% would increase the pension fund value of an average earner after 46 years of saving by 5.5%. The effect of fees and buying a poorer value annuity can wipe far more than this off the value of your pension fund in one go.

Does using the Money Advice Service help? The Money Advice Service has a section on annuities and also allows people to type in their details and find a selection of annuity rates. I conducted a mystery shopping exercise on the Money Advice Service website and entered details as a 65 year old married man who is living with his wife. I selected a single life annuity, which meant there would be no provision for a wife after the husband died. The Money Advice Service calculator provided the quotes for just a single life annuity. The calculator did not in any way flag up that I might want to buy an annuity that might make provision for a widow. Many advisers and even on-line self-select services will try to flag this before buyers make such an irreversible purchase. Disappointingly, the Money Advice Service annuity engine (which only includes a limited range of providers) does not provide the ‘Advice’ or even sufficient guidance at the most crucial points, to give customers the best chance of finding the right product.

Annuities are not a ‘normal’ market: The market for annuities is not like most other markets. From time to time, annuity companies simply do not want to sell annuities. When that is the case, they drop their rates to very low, poor value levels. as seems to have happened recently with the Prudential, which has become very uncompetitive in the market. Prudential quotes rates for exactly the same annuity nearly one quarter below other providers according to the Money Advice Service.

Will the ABI annuity window help people find the best provider? No. Neither the ABI website, nor the Money Advice Service actually include all the providers in the market and both services are not ‘real-time’ so the rates may change by the time someone calls to inquire what the current rate is. One of the problems of relying on either the ABI window or the Money Advice Service is highlighted in the table below. Even if someone does know what the best annuity for themselves will be and then tries to shop around for the best rate for that type of annuity, they may not find the best rate from either source.

Comparison between ABI annuity window and Money Advice Service rates

£27,000 pension fund age 65 level single life annuity	ABI window tables	Money Advice Service calculator
	Annual income	Annual income
Aviva	£1706.56 (top)	£1575.84
Canada Life	£1650.28	£1566.72
Legal and General	£1645.36	£1557.12
Prudential	£1478.92	£1294.56
Hodge Lifetime	Not in ABI	£1595.81 (top)	23.3% more than Pru

http://pluto.moneyadviceservice.org.uk/annuities

As shown in the table, the best rate on the Money Advice Service calculator is often from Hodge Lifetime, which is not an ABI member and is thus not in the ABI annuity tables. Even more interesting is that the worst rate on the Money Advice Service is from what many would consider to be a top provider – the Prudential. But the Prudential’s rates are consistently way below other providers. All other providers were quoting an annuity income of between £1557 and £1595, but the Prudential quotes £1294. There was no warning on the Money Advice Service about the poor value offered, even though buying from Prudential gives an annuity pension income nearly one quarter lower than from Hodge Lifetime. And that income will never increase.

What has happened to the value for money of annuities?There is no regulatory control on the value for money that annuity companies must offer. In recent months, it seems that the mortality cross-subsidy has largely or wholly disappeared and many companies are offering such poor rates that people will need to live to nearly 100 before they are receiving anything other than their own pension fund back (with an assumed 3.5% investment return being made by the insurance company on their original money). If the person has to live to nearly 100 before the insurance kicks in then one might consider that selling annuities at such poor rates is rather like PPI mis-selling – most people will never be able to claim on the insurance policy they are buying. Taking the rate offered under the Money Advice Service and assuming a 3.5% interest rate earned on the pension fund, the Prudential quote would require the customer to live to 102 before they are paying out more money than they received from the pension fund. For every customer who dies before age 102, the Prudential will still retain some of their original pension fund.

Do Defined Contribution trustees look after their members properly? Unfortunately, trustees of money purchase pension schemes generally do not do enough to ensure their members get best value when deciding what to do with their accumulated pension fund. The trustees often just send members to an annuity broking service without informing them of all their options, including letting them know that they do not actually have to buy an annuity at all and mentioning the risks of buying the wrong type of annuity. In many cases the members would be better delaying annuity purchase. The Pensions Regulator’s latest guidance for trustees suggests there is no difference between sending members to an annuity broker or an independent financial adviser. This is a missed opportunity, since only with a financial adviser will workers have the best chance of making the right choices – whether to buy an annuity, if so what kind and then getting the best rate. Annuity brokers cannot be relied on to achieve all those important elements.

A new approach to drawing pension income from pension funds is required: The inflexibility of annuities and the one-size-fits-all approach suits sellers of annuities, but not buyers. As an investment product, the returns offered by annuities are appalling. Many buyers would be better off using their pension fund to buy a portfolio of corporate bonds rather than buying an annuity. As an insurance product, annuities are also poor value, because people have to live to advanced ages before they get any value from a mortality cross-subsidy.

Income may be safe, but capital is at risk: When buying an annuity, the income stream may be safe, but it stops as soon as the person dies, so their capital is at risk. Despite this, nobody has to give risk warnings before buying annuities. For many years, an annuity just pays back a small part of the original pension fund, but as soon as someone dies, what is left of the fund goes to the insurance company.

Conclusion: Annuities are designed to provide a secure income in retirement. People are encouraged to save during their working life and then should have an income that meets their needs in later life. Unfortunately, annuities are no longer an appropriate way to achieve this. This is because annuities have become much worse value – annuity rates have fallen sharply over the years and the latest falls following the Bank of England’s Quantitative Easing policy, have left annuity rates near record lows. In addition, people are living much longer in retirement than they used to, so annuities have to last longer than they were originally designed for. Many people are now working beyond state pension age, so encouraging people to buy annuities is not serving them well. If they are working longer, they may be better off staying invested and having the chance to earn more money.

As auto-enrolment proceeds, it is vital that the market works better for those who need to take income out of their pension fund. The Government has not yet recognised the problems of annuity purchase and the industry has huge vested interest in leading people to believe that the problems are being addressed as this market is so profitable for all those selling annuities. However, customers need protection and it is up to Government to step in when markets fail. This is one such situation.

ENDS
Dr. Ros Altmann