Brandon Horwitz considers whether guarantees in retail products have a future in the UK
Asked what they want from their investments, many consumers simply want a better return than cash, and the guarantee that they won’t lose money. While we are tempted to tell these consumers that they can’t have their cake and eat it, there has long been a category of retail products offering exactly these features.
However, guarantees in retail products in the UK are conspicuous by their absence today – why?
The Great Risk Transfer
The UK has an ageing population, and defined contribution pensions (particularly ‘pension drawdown’ products) are becoming increasingly commonplace – especially since the introduction of pension freedoms in 2015. While these products give consumers more flexibility in terms of how and when they access their pensions, they leave customers exposed to investment risk and longevity risk.
Many consumers are also not accessing or receiving financial advice today, especially those who have more modest pension pots. This means they do not receive help to address the impact of negative investment returns early in retirement on the sustainability of their income (often called ‘sequencing risk’), and the resulting effect on the chance they will outlive their savings.
This illustrates the issue of the Great Risk Transfer (bit.ly/2Q061Rf), the situation where financial risks previously borne by government and institutions are now transferred to individuals.
What are these products?
Guaranteed products typically offer a return of capital guarantee and/or a guaranteed level of income (either fixed, or with a minimum level plus some ‘up-side’ linked to investment returns). The guarantees can be delivered through options or other types of derivatives, or through a dynamic approach to asset allocation (including algorithmic approaches such as constant proportion portfolio insurance, or CPPI).
These products can be delivered to consumers through structured products offered by banks, or in insurance-based investment products (including unit-linked or with-profit style products).
Why have these products disappeared?
Changes in the UK distribution market for investment products are a key reason for the absence of these products today. The Retail Distribution Review (RDR), implemented in 2013, banned commission payments from providers on new business, instead requiring advisers to charge explicit fees. Guaranteed products became less attractive to sell, with advisers focusing on clients with higher net worth, to whom they can sell ongoing advice services.
With-profits – a classic guaranteed product – has been falling in popularity since the early 2000s. Reasons include a number of high-profile scandals (including Equitable Life) and links to mis-selling of mortgage endowments. Many with-profits providers have also found themselves in a weaker financial position, adding to the challenge of regulators’ continued scrutiny of them.
Structured products have also suffered from reduced confidence since the failure of some providers, such as Lehman Brothers in 2008, as well as the fact that there are now fewer retail distribution channels, with many banks exiting the advice markets after the RDR. The Financial Conduct Authority (FCA) also introduced explicit product development and governance requirements for structured products after failings were identified in thematic work it undertook in 2012 and 2015. These requirements include treating the customer fairly, and requiring products to have a reasonable prospect of delivering value to customers in the target market.
Fundamentally, all structured products (and guarantees) depend on interest rates, which determine the cost of the capital guarantees involved (ie the price of the ‘zero-coupon bond’ element of the guarantee). With short and long-term interest rates at 30-year lows, the costs of these guarantees have risen substantially – so providing value to customers is increasingly difficult.
What did we find?
Our working party identified four themes which contribute to the fact that these products are out of favour in the UK:
- Understanding of guaranteed products: Understanding among consumers and advisers varies considerably, especially when it comes to the benefits and opportunity costs of guaranteed products. People also have negative associations with past mis-selling scandals, and perceptions that these products offer poor value for money. We also noted that the traditionally ‘backward-looking’ product disclosures may not fairly illustrate the benefits and limitations involved.
- Limited manufacturing expertise: Relatively few actuaries (and other professionals) have the experience needed to create and manage these products, as it requires specialist skills covering economic capital and asset/liability management, including expertise with derivatives. This type of work would be well-suited to with-profits actuaries, but relatively few of them work on ‘new’ products (versus legacy business) today – and few, if any, are being trained to develop new products.
- Perceived regulatory risks and scrutiny: Guaranteed products are perceived as too risky to develop by many firms, which fear FCA scrutiny or sanction if they ‘get it wrong’. This fear is informed by historical issues such as mis-selling scandals, provider failure, and poor value for money (including the role of high commissions in sales before the RDR). The FCA also now sets high product development standards, which include explicit value-for-money requirements.
- Solvency treatment of guarantees: There are significant capital requirements involved in offering guarantees, and Solvency II standard formula firms have limited ways to manage these requirements.
“The costs of these guarantees have risen substantially – so providing value to customers is increasingly difficult”
What could help promote a market for these products?
We believe there is an unmet customer need that can be satisfied by these products, and identified four recommendations to help promote a market for them:
- Education and balanced promotion: Consumers and advisers would benefit from education about the benefits and limitations of guaranteed products. This could include a focus on the ‘in-retirement’ applications of these products to help secure a minimum level of income, which helps address sequencing and longevity risks. We also believe that balanced promotion is required, making it clear to consumers that the benefits of guarantees come at a cost (including quantifying the opportunity cost of returns given up). We think forward looking stochastic projections are a useful tool to show this as part of financial planning and value-for-money analysis.
- Develop skills and transfer experience: We should train actuaries to develop the skills needed to create and manage guaranteed products. This would involve creating opportunities for experienced actuaries to transfer their knowledge to the next generation. One way of doing this would be to refresh and promote with profits techniques.
- Fair value and regulatory ‘safe harbour’: Fair value to consumers should be a core principle when designing guaranteed products, which should follow the letter and the spirit of FCA product governance regulations. We also believe it is important to engage with the FCA concerning a potential ‘safe harbour’ for products that meet a set of standardised features. This could involve developing an actuarial standard for fair value assessment.
- A different standard formula: There could be a case to consider a different standard formula in Solvency II (or any UK-specific solvency framework post Brexit) – a formula that is more reflective of the economics of guarantees. In particular, there could be more allowance given for the ability to closely hedge liabilities with widely available and transparent derivative products.
We have completed this stage of our work and there is appetite from the Life Board to support further work on this theme, including a look at the role played by annuities in delivering guarantees. Please get in touch with me if you are interested in this subject or any subsequent work.
Brandon Horwitz is an independent consultant, non-executive director and actuary, and chair of the Long Term Product Guarantees Working Party