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The Actuary The magazine of the Institute & Faculty of Actuaries

A pension for the job

The traditional compulsory purchase annuity (CPA), it seems, is currently the contract that everybody loves to hate. The steady decline in CPA rates means that people retiring today receive a much lower income from their after tax-free cash pension fund than their predecessors who retired only a few years ago. As well as pensioners and consumer journalists, critics include individuals and organisations with a vested interest in promoting alternative, mainly equity-based, products of their own. But many of the arguments put forward have been flawed.
There are two main reasons for the decline in CPA rates. The first is the slide in the income yielded on the long-dated fixed-interest stock in which reserves are invested. The second is the progressive improvement in pensioner mortality. It is the real return which matters, however, and in this context CPAs still offer excellent value. In a paper presented to the Institute on 24 May 1999, senior members of the profession made their opinion clear that the current low-inflation low-interest rate environment is no passing phase; there is even a possibility of negative inflation, although not the malignant type seen in the UK between the world wars.
CPAs, of course, do not have the approved pension income field to themselves. Drawdown products, allowing individuals to extract an income directly from their pension fund, have been around for some years. However, the market for these lies with sophisticated and wealthy individuals, who have other sources of income and capital, who are aware of the risks involved in investing mainly in equities at a fairly advanced age, and who can afford the high costs of ongoing advice. The current consensus among IFAs is that the minimum fund for drawdown should be £250,000. Drawdown is not a product for the mass market. That is a field that CPAs have and, I believe, should continue to have all to themselves. Single premiums tend to be modest. According to ABI statistics, the average amount invested in 67,000 CPAs in the final quarter of 1998 was £21,866.
For the vast majority of members retiring from occupational schemes and individuals with vesting retirement annuities and personal pensions, CPAs offer a number of key advantages:
– They are simple to understand.
– The pension fund money is applied to buy an annuity guaranteed for life.
– There is no danger of the pension fund being run down to nothing.
– Money is pooled with that of many other pensioners and the reserves invested in fixed-interest stock.
CPAs provide a steady flow of income, paid under PAYE like a salary. They also offer value for money. The market is extremely competitive, and the company offering the most competitive rate should win the business. There are still, however, too many instances where, through inertia or ignorance, open-market options are not brokered as they should be. Perhaps this is something that the regulators can put right.
Leading providers invest reserves in corporate bonds which provide higher yields than gilts, and it is the life office rather than the pensioner that carries the risk of borrower company default. Life expectancy has been and is anticipated to continue rising steadily, but a major medical breakthrough for example, the finding of a cure for cancer could cause average longevity to leap. Again, it is the life office (and, possibly, its reinsurers) rather than the individual that carries the risk.
There are now a number of ways of enhancing the returns available from CPAs to those in the mass market group. Unit-linked and with-profits annuities have attracted the attention of the media, but they are certainly not for everyone. Although they offer higher income potential, they are more complicated than traditional CPAs and payments can fluctuate over time.
There are also increased annuities for smokers and pensioners with certain health problems. But a more recent development has seen the introduction of enhanced annuities for residents of ‘high-risk’ geographical areas who previously worked in manual occupations. There is a wealth of general population data which shows the relationship between residence, occupation, and average life expectancy: manual workers in the north of England, Scotland, Wales, and Northern Ireland tend to experience much higher mortality than, for example, white-collar workers in the South.
There is nothing new in this. For years actuaries have applied these statistics in the pricing of group life and PHI products. Typically, the cost of cover for workers in a Motherwell foundry would be much higher than that for bank administrators in Surrey. Now actuaries are using the data to calculate CPA rates. One can only guess at the underlying reasons for the mortality differences between population groups: education, lifestyle and habits, diet, hygiene, access to healthcare services, and the degree of wear and tear on the human body, for example. But differences there certainly are. Why should a retired Newcastle shipbuilding worker effectively subsidise the pension of a former accountant in the South? No longer does he have to.
The real challenge facing the nation, the life insurance industry, and the actuarial profession goes much deeper than the choice of income vehicle in retirement. It is how to convey to the public the need to build an adequate pension fund during a working career. People have to start contributing earlier and, with help from their employers, they have to contribute more.