Changes to pension rules announced in March's Budget sent shockwaves through the industry, with some commentators declaring the death knell had been sounded for the annuity market.

The consensus is that sales of annuities - particularly the single life level that most people purchase today - are likely to fall by 80% or more. In Australia - often used as an example of innovative pension practice - a mere 29 single life level annuities were sold in 2013, demonstrating how unpopular these products are in markets where people have free choice over how to manage their retirement savings. The UK, by contrast, has the world's biggest annuity market, with some 420,000 policies purchased each year. Chile comes second, with 22,000 policy sales.

An interlinked series of problems has brought the pensions market to the point where change was probably inevitable: increasing average life expectancy, little change in retirement ages, very low interest rates (and therefore low annuity rates), little genuine choice of pension products and insufficient saving.
"The hope of some within the industry is that people will be able to take the 'do nothing option' upon reaching retirement age"Others argue that, on top of these factors, a bombshell was inevitable given that there was no requirement for any suitability checks before selling a standard single life level annuity.

Annuities sold to most people in the UK fail to meet their needs for several reasons. They have no link to inflation, so people's income decline in real terms through what is frequently a 20- to 30-year retirement; they do not preserve capital, so that it could be bequeathed as part of an estate; and they do not enable people to access their money should they need to meet care costs in old age. Their lack of flexibility means that once purchased, the holder forfeits the chance to benefit from future increases in interest rates and from continuing investment returns, and cannot switch to any new products that might be more suitable for them.


What's in the wings?BlackRock, the world's biggest asset manager, is considering developing new retirement products for the UK market, possibly based on the LifePath products it offers in the US.

The market is expected to evolve to provide a new set of choices for people who reach their scheme's retirement age, including trustees offering members the chance to take their savings as cash, or leave them invested with the fund and start taking an income without buying an annuity.

420,000
The number of polices purchased in the UK's annuity market each yearThe aim would be to provide a 'mass-market drawdown product' fund that pays an income broadly equivalent to an annuity. Leaving retirement savings invested in financial markets beyond retirement age helps to preserve flexibility and access to the capital. It can also offer a degree of inflation protection, depending on what assets the fund is invested in.

AllianceBernstein already markets a version of this product as Retirement Bridge. It enables people to delay buying an annuity until they are in their mid to late 70s, by which time they start to offer much better value and it makes sense to switch to a guaranteed income based on an insurance policy.

Annuity best-buy tables suggest a standard level annuity bought at 75 will provide about 33% more income than one bought at 65. Buying later is also better business for insurance companies as the capital requirements are considerably reduced because of lower longevity risk.


Lower costsSo an important part of the future for pensions is likely to be the appearance of institutional 'scheme drawdown' options that allow people to take an income that is managed by their pension scheme until they are in their mid-70s and, while doing so, to benefit from the lower costs that institutional buyers can negotiate on their behalf. They would then have the choice of taking their savings as cash, buying an annuity, or taking an in-plan option that pays a much lower income because it preserves the client's capital.

However, there is likely to be some re-engineering in the annuities currently on offer. Features that might be included in future are a means of capital protection and some form of lump sum on death.

Challenger, the biggest annuity provider in Australia, offers policies that, for example, pay out a lump sum on death that diminishes the longer the policyholder lives, reaching zero if the annuitant survives past 95. There are also likely to be products that provide cover should residential care become necessary. Annuity providers need to offer a much wider range of product features that can adapt better to individuals' circumstances.


Upon retirementThe hope of some within the industry is that people will be able to take the 'do nothing option' upon reaching retirement age, leaving their savings invested while drawing an income and delaying big decisions such as when and whether to annuitise.

However, large insurance companies might not favour this option. They face the imminent threat of a big decline in new business, coupled with a long run-off of legacy books where costs are under scrutiny, and they have to continue to pay for the infrastructure to support those policies. Some could come under severe pressure, observers suggest.

Proponents of this option believe that the effect of the changes will be to shift the annuity market to the 75 to 80 age bracket, so after a hiatus of perhaps ten years or so, a significant amount of money could still flow into new-style annuities. That ten-year gap will be a painful period of adjustment for many insurers, although some are likely to benefit from increased sales of bulk annuities as defined benefit pension schemes move to offload their liabilities.

The shake-up of the pensions industry requires a creative approach that will, in time, hopefully result in a far more innovative and efficient market.

The original version of this article, written by Andrew Davis, was published in the June 2014 print edition of the Review.