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The Actuary The magazine of the Institute & Faculty of Actuaries

What assurance did the guarantees provide?

Many interpretations have been made over time of what is meant by a guaranteed annuity option (GAO), and these contrast with the House of Lords’ interpretation in Equitable Life’s particular case.
The interpretation of a GAO under a unit-linked policy is different from the interpretation of a GAO guarantee under a with-profits policy. That was the conclusion from a variety of sources:
– the Treasury’s letter of 18 December 1998 to chief executives of life offices;
– the actuarial profession’s position paper of March 1999;
– the regulator’s approval, since the end of1995, of the flexibility of terminal bonus in respect of GAO with-profits policies (this flexibility had been stated in the regulatory returns);
– counsel’s opinion to Equitable Life; and
– the view of most life offices.
Under a GAO unit-linked policy, the above evidence shows that the interpretation of the relevant bodies was that a pension is calculated to be the better of applying the full pension fund to:
– the guaranteed annuity rate; or
– the market annuity rate.
Under a GAO with-profits policy, the above evidence shows that the interpretation of the relevant bodies was that the pension is calculated to be the better of:
– applying the guaranteed pension fund (ie excluding any terminal bonus) to the guaranteed annuity rate (the result being known as the ‘floor pension’); or
– applying the full pension fund to the market annuity rate.
Therefore, under a GAO with-profits policy, the pension could not fall below the ‘floor pension’ no matter how low the stockmarket might go or how expensive market annuity rates might become.
In contrast, with-profits policies without GAOs were ‘hostages to fortune’ as to the level of the stockmarket and the level of market annuity rates when they retired. There was no ‘floor pension’.

The profession’s view
The actuarial profession deemed the risks of offering a GAO under a unit-linked policy to be very great, since they lacked the flexibility that terminal bonus provides. The profession’s view came as a result of the work done by the Maturity Guarantees Working Party in the 1980s. Under a unit-linked policy with GAOs, the life office was exposed to interest rate risk, stockmarket risk, longevity risk, and so-called ‘retirement’ risk (ie the GAO was available from age 60 to 70). Therefore there were some enormous risks in granting this type of GAO and, as there was no terminal bonus on a unit-linked policy to provide flexibility, there was no way, in the 1970s and 1980s, of alleviating these risks. As I understand it, this was the reason why, in the early 1980s, the actuarial profession recommended to life offices that they drop guarantees on unit-linked policies whereas, because of the flexibility provided by terminal bonus, the profession felt that a GAO could be offered under a with-profits policy. Most life offices took the advice of the actuarial profession. (The ‘swaptions’ market, as developed only in the 1990s, can guard against only one of the aforementioned risks, namely interest rate risk.)

The judges’ views
The judges in the Equitable Life Assurance Society’s House of Lords case interpreted the annuity guarantee under a GAO with-profits policy to apply to the full pension fund. This makes perfect sense in relation to GAO unit-linked policies but, as we have seen above, goes completely against the views of the Treasury, the regulator, legal counsel, the actuarial profession, and the life industry in relation to GAO with-profits policies.

The wrong conclusion?
If, on a GAO with-profits policy, the full pension fund (subject to any smoothing) has to be applied to the better of the (a) guaranteed annuity rate or (b) market annuity rate, then:
– As exposure under a GAO increases with decreasing interest rates, the industry has created ‘probably the largest naked interest rate option that the sterling market has ever or is ever likely to see’. (quote from Ian Collier article ‘Hedging Annuity Guarantees’ in The Actuary of December 1998).
– As exposure under a GAO increases with increasing equity prices, the industry has created ‘probably one of the largest naked equity options that the sterling market has ever or is ever likely to see’.
– As exposure under a GAO increases with increasing longevity, the industry has created ‘probably one of the largest longevity options that the sterling market has ever or is ever likely to see’.
– A life office with GAOs is also exposed to ‘retirement’ risk.
I believe that the judges, in the Equitable’s House of Lords case, were not adequately informed by the lawyers bringing the case. One may ask whether the judges were aware of the above evidence and, in particular, the contents of the Treasury’s letter of 18 December 1998. It is being asked whether the Treasury and the regulator gave evidence at the House of Lords case.
I believe that the Law Lords were not informed that:
– The evidence of the bodies cited above is that the interpretation of GAOs on with-profits policies allowed flexibility in the terminal bonus.
– The Equitable’s GAO policy document (typical of other offices’ GAO policies), as judged by Lords Scott and Morritt, who were both experts in contract law, allowed flexibility of the terminal bonus.
– Without flexibility of the terminal bonus, a GAO would probably result in ‘the largest naked interest rate, equity, longevity, and retirement options that the sterling market has ever or is ever likely to see’ and would be close to bringing a once proud life industry to its knees.
– As market annuity rates at age 65 are now about 7% per annum (as opposed to a typical guaranteed annuity rate of 11.11% per annum) the cost to the industry of providing GAOs with no flexibility in terminal bonus would be some £30bn.
– If market annuity rates had fallen to 5.55% per annum as they have done in Japan, then more or less the whole life industry in the UK would have been rendered insolvent.
– The actuarial profession had recommended as long ago as the 1980s dropping GAOs on unit-linked business for the reason that the risks inherent in such an option were enormous as there was no flexibility provided by terminal bonus.
– Those policyholders in the Equitable without guaranteed annuity rates (non-GARs and with-profit annuitants WPAs) feel an injustice has been done to them as, with no estate, there was only a finite cake for all policyholders to divide up. The bigger slice being allocated to the GARs automatically meant that a smaller slice was allocated to the non-GARs and WPAs. The WPAs, in particular, never realised that their slice of the cake could suddenly become smaller.

What Penrose should have concluded
In my view, the Penrose inquiry had the ideal opportunity to reach the scientific truth but, under their terms of reference, the inquiry was not allowed to examine the House of Lords’ judgment. If a panel of expert persons, including an expert in the law, had been assembled and given the task of reaching the scientific truth uninhibited by any former legal judgments, it is my view that they might have concluded as set out below.
– The Equitable Life’s interpretation of the GAO on with-profits policies did not infringe the legal contracts.
– When these GAO with-profits policies were written it was economically impossible to invest to provide whichever is the better of two pensions because no financial market supplied the necessary assets to do this.
– The Equitable Life’s GAO policy was written to provide the benefits as an annuity with bonuses, ie in annuity form. However, the Equitable only quoted policy values in cash form, including accrued terminal, as the policy went along. If the Equitable, in line with other life offices, had stated the reversionary bonus in annuity form (and not quoted the accrued terminal bonus until maturity) the issue would probably never have arisen,
– The legislation (in particular the Finance Acts 1970 and 1978) had been written to give the policyholder the option of commuting about one-third of the pension for a cash sum or of converting the pension into a cash sum and taking this cash sum to another office under the ‘open market option’. This requirement of the legislation, namely to have benefits available in both cash and pension form and with a fixed factor converting one into the other, has been partly to blame as it is asking the economically impossible.
– There are huge naked risks which are ‘unhedgeable’ (in the sense that a life office cannot protect themselves by hedging out these risks) in interpreting the full pension fund on a with-profits policy as having to be applied to whichever is the better of two annuity rates. In the early 1980s the actuarial profession recommended dropping GAOs on unit-linked policies for just this reason.
– A GAO on a with-profits policy has to be interpreted to exclude terminal bonus otherwise the whole life industry would be either insolvent or severely dislocated and the reasonable expectations of policyholders without guaranteed annuity rates would be infringed. The high number of referrals to the Financial Ombudsman Service seems testimony to this.
– The judgment has led to increasing costs as a result of sequential steps from which none has so far benefited and from which most have suffered.
The Law Lords’ judgment was only as good as the information given to them and, in my view, this information was inadequate.