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The Actuary The magazine of the Institute & Faculty of Actuaries

Annuities time to change the game?

There has been a great debate in the UK about the legal obligation to buy annuities with the proceeds of money purchase pension schemes, whether personal or occupational. The government has recently published its long-promised consultation paper on the future of pension annuities (‘Modernising annuities’, produced by the Inland Revenue and Department of Work and Pensions). However, the political debate has perhaps tended to obscure issues that may be more fundamental and which should be of great interest to actuaries.

Macro development and micro changes
It is increasingly acknowledged that the shift to defined contribution pensions, combined with social and economic changes, will mean that the funds built up to provide pensions in future are likely to be smaller than under defined benefit arrangements, and the income generated by those assets will be low by historical standards. Therefore, the need for annuitisation simply to squeeze more income out of assets will increase, not decline. Along with this macro-development, there are micro-changes which will affect every life company either providing annuities now or intending to do so in the future.
Instead of an annuity market where most of the products are very similar, we are looking at much greater differentiation in both the risk rating of annuities and the investments associated with them. This might be called an ‘unbundling dynamic’, and the thrust of change appears to be broadly as follows:
Over recent years the proportion of annuities written on enhanced or impaired life terms has risen sharply from a small base and is understood to be heading towards 10% of the total. Some offices have also begun to introduce more sophisticated rating into the calculation of standard annuity rates, even where these are not specifically referred to as enhanced or impaired life. As the proportion of the specially rated annuities increases, the characteristics of the pool of lives to which standard annuities are issued is changing materially. The less sophisticated raters run the risk of anti-selection and will either need to accept even lower levels of profit (or greater losses) on traditional annuities, or will need to strengthen rates.
However, without careful analysis, a number of annuity providers may find it difficult to respond effectively. If we assume that rating does adapt, then many annuitants, particularly those from social groups with greater longevity, will feel even more aggrieved at the terms on which traditional bond-based annuities can be obtained. A possible response from annuity providers and we seem to be at an early stage in such a response is to move towards greater provision of investment-linked annuities, so that at least the more sophisticated customers can attempt to compensate for the higher costs of longer lives by investing in what they may perceive to be potentially higher-return investments.

Adequate charging
A further development seems likely. It seems doubtful that at present most annuity providers are charging their customers adequately for guaranteeing the price of longevity over very long periods. That is not to say that existing estimates will be wrong, only that the uncertainty of outcomes is high and may not be fully reflected in the pricing of longevity. Were we, for example, to have a market in longevity bonds, one might expect a greater reward to accrue to bonds of longer duration. A further development, which indeed would result from such a market but can be expected to emerge anyway, is that a greater choice of more limited longevity guarantees may be offered in annuity products. An example of a structure that would permit such a development was given in the paper ‘Reinventing annuities’ presented to SIAS in January 2001, and there are products now in the marketplace that allow providers to offer more limited forms of longevity guarantee. The ‘unbundling dynamic’ described above can be summarised in figure 1.
An important point to make about this cycle is that not responding could be a dangerously unprofitable strategy. Multivariate rating of longevity, where the terms more closely reflect the experience of the particular annuitant or group of annuitants, seems inevitable and, after all, merely follows changes that have happened in non-life markets, such as motor and household. Indeed, some of the statistical tools that our colleagues in non-life work have developed may, particularly for longevity guarantees of shorter duration, be particularly appropriate. In the future, actuaries working on annuities will need:
– to invest much more time in understanding and analysing the risks that they are writing;
– to develop more sophisticated tools for analysing these risks;
– to devise a variety of annuity products covering different market sectors;
– to be much more selective about the business that they will or will not write.
Competitive pressures are likely only to increase in the future as a consequence of regulatory change to promote greater use of open market options. Such changes will reinforce the unbundling dynamic described above.