This post is written not by an actuary or risk manager but by someone who is 63 and faced with the predicament of choosing between an annuity or an income drawdown policy to fund his remaining 25 or so years. While I address a professional audience, I do not write as a professional but as an inquisitive amateur looking for resolution between insurance and investment. Yesterday I saw a chink in the clouds and hope that in the next 1000 words I can share some of the light that seemed to come shining through!
There are two competing views of pensions as a socially desirable financial service.
The first is that they offer the economy a vast po0l of unspent wealth that can be put to work to solve problems as various as the change in the climate, the lack of housing and shortage of capital for productive expenditure by business.
The second is that pensions insure against people living too long and are a hedge against the societal issues of longevity.
If you work in the Treasury, you probably think more about the first and if in the DWP the second but the two views need not be exclusive to each other.
The chink of light
Yesterday I was in a meeting where we were looking at providing pensions to those with investments but no “wage for life” – at least as a financial service. A wage for life solution is of course available – the annuity. But for those who are in their fifties and sixties, the thought of surrendering the opportunities of investment in return for the returns on a portfolio of bonds has not proved attractive. George Osborne did not release us from mandated annuitisation for nothing. However, as Steve Webb and many others have shown, the attractiveness of an insurance against old age, increases over time. Economists call this attraction “utility” – certainty that your money will last as long as you do – brings happiness.
As I sat in this meeting, it dawned on me that the investment of capital in long term assets to provide gilts +2 returns can be married with the wanted risk of insurance which has to balance the risk of people dying too soon (life insurance) with the risk of them living too long (lifetime annuities). Necessarily, investment propositions use longevity hedging to remove what is “unwanted” to them, with what is “wanted” to the life insurer. There is a market in live and dead souls that post-dates Gogol!
The struggle between investment driven pensions – the superfunds and bulk annuities need not be an argument. Clara has proven that a “bridge to buy-out” provides a synthesis between the Treasury and DWP view and the use of a bulk annuity is not that different from the use of reinsurance from a superfund with longer time horizons.
There is necessarily a cross-over point where an annuity becomes more economically viable than an investment backed with reinsurance and determining that point is something that I think about a lot. Indeed, the modelling we do with apps suggests that individuals are better buying an annuity from about 70 than a scheme pension (but are better buying a scheme pension before that point.
However, this being the case, might there not be an opportunity for scheme pensions to embrace annuities automatically within a single journey for the member so that they start their pension invested (with TPR capital backed guarantees) and end it insured (with the buffer coming from insurance solvency requirements).
Since the failure of a scheme pension is (to statutory increase levels) backed by the PPF to 100% of the pension paid and the failure of the annuity (to similar levels) backed by FSCS to 100%, and since solvency and buffer funding standards are designed to provide equivalent protection against failure, cannot we reasonably assume that a member is as safe in a scheme pension as in an insurance arrangement. Indeed the only complexity for the member is whether in the event of failure, their pension continues to be paid by a fund created by occupational pensions or from an arrangement funded by financial services companies on a pay as you go basis. Who cares?
My friend and mentor , Edi Truell, founded and ran an insurance company providing longevity protection (Pension Insurance Company) and has been offering capital to back pension promises as an investor through Pension Superfund – ever since. If anyone can see risk from both ends of the telescope it is Edi Truell.
We left the meeting convinced that we were not competing with insurance but synthesising insurance and investment using the best aspects of pension scheme funding and annuity funding by accepting that investment and insurance are equal but different.
We have been asked by the Government to bridge the gap between DC and DB (Laura Trott), to create full service pensions (Nausicaa Delfas) and to create a choice architecture with a strong default (FCA and TPR).
We know that there is a strong undercurrent of demand from ordinary people for workplace pensions to pay pensions. We know that the state pension is loved and trusted. We talk of both DB pensions and annuity buy-out as gold-plated. But it is only in DC that we consider a DIT pension called “income drawdown”.
There is a market for drawdown, and it is primarily driven by those with sufficient capital (or income) not to need a wage for life solution. This market is satisfied by advisors. The remaining market for retirement “solutions” is for pensions. It is up to those who care about DC workplace pensions to find ways to provide the equivalent of DB pensions through the tools that pension funds and financial services organisations have at their disposal.
Pensions as investments and pensions as insurance can be synthesised in new defaults that offer the advantages of both – both in terms of “wanted” risk, and in terms of “wanted return”. Better pensions than can be afforded by non-invested annuities, better insurance than can be found from investment pooling. We really do need to work together to sort the nastiest hardest problem in finance – finding a product that makes sense to the ordinary savers who right now have the wrong kind of choices, for what they want and need in retirement.
