UK Pension reforms and the annuity business

by George Hatjoullis

The immediate response to the UK pension reforms was to declare the death of the annuity. The share prices of insurance companies that had significant exposure to the annuity business suffered and wild stories emerged of how the housing market would get another boost from funds immediately withdrawn from pension plans to invest in buy-to-let. This is the quality of financial journalism and financial literacy that I have come to expect and motivates me to write this blog. The rapid withdrawal of funds for buy-to-let is unlikely (as I have explained at length in previous blogs) because it would be at the higher rate of tax. House prices would need to rise by 40% just to get the value of your pension back to where it was before withdrawal. Not a good investment strategy. If you already own a property then you are already in buy-to-let-to-yourself and adding to this is, in any event, not a good strategy as you will be undiversified. If you have a large portfolio it may make sense to add buy-to-let but this would only be true of a few. For most pensioners buy-to-let is neither possible nor appropriate.

The annuity business has been dealt a blow in its present form as it has lost the easy compulsory purchase business. The pension reforms have given the average pensioner more flexibility (which is a good thing) but has not altered the basic pension arithmetic. How does a pensioner make a fixed pot last an uncertain life time? (The appeal of buy-to-let is the apparent certainty in the rent and the value of the property over an indefinite period. However, Personal Finance 8 goes someway to explain why it is not as certain as it may appear. Nothing is certain which is why diversification is such a good idea) There are two sources of uncertainty; how long will you live and what will be the investment return?

In previous blogs I suggested it would help if insurance companies would offer death insurance. This enables a pensioner to better plan resources to a fixed date because she can also buy a policy that pays out if she lives beyond a specified date. Death insurance is not available to individuals in the UK but the equivalent policy, a deferred annuity, is available in other countries (e.g. USA). I predict that UK insurance companies, having been deprived of easy compulsory purchase business, will now become more ‘innovative’ and offer deferred annuity products.

The deferred annuity, as the name applies, only kicks in after a specified date. You give an insurance company £x today (or periodically in smaller sums) and if you live beyond a certain date the annuity comes into effect and pays out an income. The amount of income depends upon the terms of the annuity. The insurance company deals with the uncertainty of returns (if you choose) and you pool your longevity risk with all other pensioners taking such policies. As with current annuities some people will live a long time and others not so long. The early ‘exit’ customers subsidise the late ‘exit’ customers. This pooling of longevity risk is how all insurance should work (but increasingly does not). The deferred annuity, properly structured and priced, meets a need that most pensioners have and provides a source of business for insurance companies.

You can, of course, set aside the premiums in a long-term investment that is designed to yield a lump sum after a specified date and then plan to consume other resources by this date. The investment would form part of your estate if you die before this date whilst a deferred annuity will not. The deferred annuity expires when you expire.  Using an investment does not capture the benefit of pooling longevity risk. This pooling allows a larger guaranteed annuity per unit of premium than is possible simply by investing the premiums (or, at least, it should). If the investment return is 5%, you retire at 65 and expect to live until 85, then £10k will become £25,533 by the expected expiry date. This is the basic amount the deferred annuity provider has to provide you an annuity at age 85. However, the provider also has the premiums of those that have expired before their deferred annuity date. Moreover, there is some expectation of how long a typical 85-year-old will live beyond 85. A basic £10k could in principle provide more income in 20 years than might at first seems likely. Of course, this insurance or pooling principle does not work if the deferred annuity comes with a death benefit that pays out the premium plus returns on death to the estate. Nor does it work if insurance company charges are too high. But the principle is sound.

As a postscript it is worth noting that risk pooling is the essence of insurance and the more insurance companies segregate insured populations the less ‘insuring’ that is being offered. DNA testing, postcodes, occupations etc all segregate the population into categories and enable insurance companies to better estimate the actuarial risk. However, it reduces pooling and the premiums for some are very high and others lower. In the limit, if the insurance company knows exactly the probability of an individual incurring an insured risk then this individual cannot get ‘insurance’ as such. I first lamented the EU directive to stop insurers discriminating against men and women through premiums. I was wrong. Whatever the motive of this directive it has improved the availability of genuine ‘insurance’ because risks are now pooled across men and women instead of consisting of two separate pools.

 

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