Charlotte Moore discusses how to increase awareness of the various options available at retirement and the need for a rejuvenation of annuity products

Difficult market conditions can be a force for good: they can provide the impetus to instigate much needed change. DC scheme members currently have limited choice about how they fund their retirement but there are encouraging signs that the industry recognises this situation has to be improved.

The standard practice is for DC members to purchase an annuity on retirement that will provide an income until they die. The low-interest rate environment, however, means that members are currently receiving reduced levels of retirement income from their annuities.

According to a recent report by the NAPF, in early 2008, a £100,000 pension pot for a 65-year old single man would have bought an annuity income of slightly less than £8,000 a year. Four years later, the same pot would secure an income of just over £6,000. That’s a reduction of almost 30 per cent.

It’s depressingly common for members, on reaching retirement, to simply buy the annuity offered to them by the insurance company that provided the DC scheme. This is likely to lead to a woefully inadequate retirement income. At the very least, it should be much easier for members to shop around for the best deal.

It’s not only the low interest rate environment that’s made the pension industry pay more attention to annuity pricing: both The Pensions Regulator and trade bodies have started to pay more attention to ensuring that DC schemes provide the best possible retirement for its members.

In a separate report, the NAPF highlighted the inadequacies in the current system, pointing out that fewer than one in five people had the necessary financial skills to pick the right annuity product. It said there was little point in encouraging people to save for retirement if the industry then fails to help them to make the most of those savings.

As the DC industry is relatively young, much of the industry’s focus in recent years has been on improving the default fund to ensure that individuals have the right type of investment vehicle to build up a pension pot.

It’s only recently that DC schemes have started to look at ensuring that this pension pot can be used to purchase a reasonable retirement income.

The Open Market Annuity Service director Graeme Riddoch says: “DC solution advisers are starting to realise they will lose mandates, clients and tenders if they do not act swiftly to improve their currently weak decumulation proposition.”

There is one simple step that DC providers can use to dramatically improve the choice available: they can use an automated system that can search the market to find which one of the 60 available annuities is the best for the member.

Riddoch says: “We’re seeing an increasing number of DC solution advisers interested in talking to us about our annuity comparison service.”

Increasing awareness among DC scheme members of the options available to them when they come to purchase an annuity policy is equally important.
Gemma Goodman, head of The Annuity Bureau at Alexander Forbes, says: “The industry needs to put more emphasis on ensuring that members understand that they have options when they come to retirement and help them to understand those possible options.”

Traditional annuity products can be divided into conventional and enhanced products. Conventional products can either be linked to inflation or provide a flat retirement income.

Enhanced products offer higher levels of income for individuals who have either have medical conditions or made lifestyle choices that mean they have less chance of living for long.

“Individuals with some form of medical or lifestyle condition that could shorten their life expectancy could find, for example, that they could get 20 per cent to 30 per cent higher income than they would receive from a standard annuity,” adds Riddoch.

There are 1,500 different factors that could result in a higher income so it’s now the majority not the minority of retirees that qualify for enhanced annuities.

But even shopping around for the best product can only improve but not dramatically change the value that annuities currently offer today. That’s spurred some annuity providers to come up with new ideas.

One product in particular that’s gaining traction in the market is the fixed term annuity. While traditional annuity products will give the owner a guaranteed income until they die, a fixed term annuity will give an income for a three, five or 10 year period.

Goodman says: “Some people are using these products because it means they do not have to commit to an annuity that pays such a low income for the rest of their life. Others believe that they might be able to qualify for an enhanced annuity if their health deteriorates over the term of the fixed term annuity.”

Other products on the market allow pensioners to still have access to investment returns. Prudential offers an investment-linked product that offers some guaranteed income, as well as a bonus if investment returns are better than expected. The product is essentially a re-working of the with-profits annuity.

Prudential business development manager Colin Simmons says: “This product has been very popular. It’s simple to understand, allows clients to still get some investment returns and protects against inflation.”

Most DC scheme members, however, are not aware of the existence of these new products. To access these products, they would have to use a financial advisor which is off-putting to most members.

But some feel that the current systems needs a much more radical overhaul and that the new crop of alternative annuity products are clunky at best and inadequate at worst.

Alliance Bernstein head of DC Investments David Hutchins says: “Take the fixed term annuity. Most people buy an annuity to provide them with an income until death. So in that respect a fixed term annuity effectively throws the most beneficial part of the annuity out of the window and all you are left with is an expensive way of buying bonds.”

The DC industry has to come to terms with the rapid changes in the retirement market. “The industry is currently too inflexible. People find it difficult to predict exactly when they are going to retire. Nor is cliff edge retirement so likely; it’s far more likely that scheme members will want to carry on working part-time and ease into full-time retirement.”

The long-term solution to the crisis in the annuity market requires a more radical solution than simply ensuring scheme members get access to all the annuity products on the market and are educated about how to manage their retirement.
Hutchins says: “An annuity is good product; it’s just that it’s bought too early. It guarantees that you will not run out of money before you die. The probability at the age of 65 that you will live to 75 is pretty high. The annuity purchase should be delayed to when you need the insurance.”

Hutchins adds: “There needs to be a product that spans that gap. It should be largely invested in bonds and it should be low cost. The point of a product like this is that it would recognise that retirement is something that should be eased into.”

The cost of these products is one of the biggest problems with this market. “We need to find a way to reduce the fees. The insurance products just have one upfront fee that makes it difficult for an investment product, which has fees staggered over the product’s life span, to compete,” says Hutchins.

Hutchins also thinks that the industry needs to apply the lessons it has learnt about default funds to the decumulation phase. “If the industry realises that member engagement doesn’t work when discussing investment options, why would it suddenly work in the decumulation phase?”

The industry should not waste the impetus provided by the low interest rate environment to find a radical solution for retirement income provision that is suitable for the challenges faced by pensioners today.

Written by Charlotte Moore, a freelance journalist

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