The publication of the FCA’s market study on annuities has not met with much enthusiasm. Consumerists do not think it has gone far enough to punish lazy insurers. Those on the sell side find it hard to understand what the brave new world of pension dashboards, hybrid and collective products and non-advised drawdown will look like.
The FCA’s problem is that while they now have a good idea what has gone wrong, they cannot predict what will go right. Specifically they have no market data to show how outcomes will be improved in the post 2015 world of unrestricted drawdown, synthetic annuities and collective DC.
Can we rely on projections – must we wait to see outcomes?
Nor will they for many years, for outcome based analysis is by definition retrospective. The projections that surrounded the last pensions revolution, the introduction of personal pensions in 1987 assumed products that might produce a 13% pa return net of charges. As the charges on most personal pensions were at least 2% pa (and for paid up policies – often as high as 7% pa, these were heroic assumptions that could only hold good in times of high inflation and strong real growth in the economy.
These were the conditions prevailing in 1987 (at least before November of that year) and they continued to the end of the millenium. But since 2000, there has been no growth in the capital value of the FTSE 100 and inflation is struggling to stay positive.
Those 13% assumptions for net growth now look surreal, but at the time I remember people worrying that they would undercook the omelette!
There has been some pressure to achieve transparency in the cost of accumulating a pension pot and there will be more as the FCA roles out its instructions to IGCs on how to value the costs of funds in which their DC policyholders are invested.
Can we get transparency to know what goes into the annuity price?
But the pricing of annuities remains impenetrable. We simply do not know enough about what factors impact the annuity rate, what the true return would be were insurers not having to retain monies to meet the various requirements of shareholders and regulators.
Alan Higham, who is now at Fidelity (an American insurer) reckons that UK annuities are priced 20% lower than US annuities taking comparable risks in the underlying investments.
This would suggest either a retention from the shareholder, outrageous inefficiencies in operation or that insurers are having to keep too much in regulatory reserves. The trouble is , even the FCA find it hard to get to the bottom of it.
Having spoken to people who I trust in insurers such as L&G and Aviva and having been shown the internal rates of return calculations on the annuity books, I do not think the insurers are shaving the rates to line their pockets. Numerous studies going back to Orzag and Murtagh in the 1990s suggest that insurers are efficient in the way they run annuities.
Can we relax the regulatory burden on annuity providers to bring down prices?
I guess that the cost of the annuity is in the Guarantee and that that cost can only be reduced by a relaxation in the reserving that insurers need to make, to meet the kind of black-swan events that did for the Equitable Life.
The price of the Guarantee that is provided by annuities is probably reasonable. The second question is whether it is a price that people are prepared to pay.
When people do the maths, they realise that they are insuring themselves against events they cannot envisage, their living beyond 100, the risk of deflation (priced in the gilt rate) and all manner of risks that could upset an insurance company in the next 40 years (which need money to be set aside for).
People buying annuities are buying into a degree of certainty that they would never contemplate in other areas of their lives. Would we only work for an employer that could guarantee us a wage indefinitely? Would we invest in a market that promised us a copper bottomed return on our money over 40+ years, would we want to bet on our friends and families dying before a certain age?
The reckless conservatism of the middle aged?
These are the things that insurance companies have to price into their annuity rates. I wonder whether purchasing a life annuity with an estimated payment duration in excess of 30 years (and this goes for most annuities sold to people between 55 and 60, is such a smart thing to do. If there is market intervention , it may be to warn people about the reckless conservatism of such purchasing.
How will non-guaranteed pension rates compare?
There is an alternative, which is to take out these guarantees and see what rate becomes available where the degree of certainty is reduced. What would be the impact of meeting promises in full 95 times out of a hundred or 97 times. How would that improve the rate compared with a 100% guarantee?
People will of course need to know what the implications are for those 5 or 3 times when the promise can be met, to know the value of their investment at risk. If the worst that might happen might be a 10% loss in the value of the income stream – ok, if 50% – not ok.
Nevertheless, the publication of non-guaranteed pension rates arising from an unguaranteed alternative to annuities would be the best way to calculate the real cost of the annuity guarantee.
Until we see what the actual returns offered via the hybrid products and the synthetic annuities and most of all by CDC, actually are. Until we can assess the level of risk being taken on by those products we cannot really assess the real cost of annuities.
Is there a proxy for the non guaranteed rate that we can use today?
But in the short term we can look for proxies. We can look for instance at the rate that the Government Actuary requires us to use to value our defined benefit pensions. It says that it costs £20 to pay £1 of escalating pension compared to £28 to buy £1 of comparable pension as an insured annuity.
From this we can assume that the price of the annuity is equivalent to the difference in these rates. If you bought an annuity of £1000 pa, you would be paying £800 more than an occupational scheme would to secure the income.
Are GAD “scheme pension and individual rates” a reasonable proxy?
I am sure that this calculation is open to challenge on a number of fronts, but at least the GAD numbers are trying to compare apples with apples.
There are of course problems with receiving income from occupational pension schemes. Some would rather trust an insurance company’s pension to their company’s promise (for instance). But were you given the choice of a non-guaranteed rate which gave you £50 a year for every £1000 you had or one that gave you around £35, you would be asking whether the margin between the two rates was justified by the risk taken.
When will the FCA market move from “interim to final”?
That is the issue for the FCA, they cannot be definitive. This is only an interim report. There is a peice of the jigsaw missing.
The problem for the FCA is also a problem for people looking to make purchasing decision in the next 2 years over their pensions. It is that we don’t know what the real price of the annuity is as we don’t know what the price of the drawdown, hybrid drawdown, synthetic annuity or CDC plan is going to be.
It makes it very difficult for advisers to make definitive recommendations and it makes for tough times for CAB and TPAS in advising people of their options (the guidance guarantee).
It makes it difficult but not impossible. In order for us to understand the possible we need to project, understand what might be. That means considering what these new options might be like and keeping an open mind to them.
Is best advice to delay taking a definitive course of action?
What the FCA paper does, and does skilfully, is to remind people that what their market study tells them in 2014 is that there is an incomplete market, that we don’t know the cost of annuities because we don’t know the price of the new products.
What the Financial Services Industry needs to do right now, is to price the new products and that is a terrifying task to existing players. It is practically impossible to re-price an existing drawdown proposition in the face of competition you can only imagine, For new entrants the question is whether to price products on “what we can get away with” or on the true price to meet reasonable returns.
What is the crucial next step?
That is the job of pricing actuaries working with pensions experts who know the market. It is perhaps the biggest challenge facing the pensions industry over the next twelve months and how the industry meets this challenge will determine the extent to which the Budget Pension Reforms lead to sustainably better outcomes or are just a mirage that disappears as you get down the road.