Stephen Lowe reflects of the history and growth of the annuity market and looks forward to the challenges and opportunities going forward
History of annuities
Annuities have been developed over more than two millennia, stretching back through the development of financial markets and new mathematical theories in the 17th Century all the way to Roman times. But the modern era arguably began with the Finance Act of 1956 which first introduced pensions that required members to annuitise the fund at retirement.
The idea was to give the self-employed the same favourable tax incentives as employed workers who had been able to obtain tax relief on contributions to occupational schemes for some time. The Act created the concept of personal pensions, with tax-free accumulation of returns within the fund although at that time there was no right to take a tax-free lump sum. It also enforced compulsory purchase of annuities, sparking the development of the multi-billion pound annuity market we recognise today.
There has been much tinkering of the rules since. In 1978, the Open Market Option was introduced giving annuity buyers the right to shop around for the best deals. In 1995 the compulsion to buy an annuity at retirement was relaxed by allowing income drawdown direct from the fund up to the age of 75. More rule changes in 2006 brought a formal end to compulsion but under such stringent conditions that few aged 75+ took advantage. In practical terms, it was only in 2011 with the introduction of 'capped' and 'flexible' drawdown that the era of compulsion finally came to end.
Many of the changes in the pensions landscape have been driven by wider changes in society, in particular the need to face up to increased longevity. Since 1960, life expectancy in England and Wales has improved by 10 years for men and 8 years for women. The government is pushing back State Pension Age to encourage us to work for longer, at the same time giving the 'baby boom' generation new flexibility when taking pension benefits.
Rising life expectancy has been a major factor contributing to the long-term fall in annuity returns. Since 1994, the average annual annuity income has fallen by 56 per cent for a 65 year old man and 50 per cent for a woman of the same age, according to financial data provider Moneyfacts.
Throughout this period, annuity sales have been on an upward trend, from just over £2.5 billion in 1994 to around £13 billion last year. Forecasts suggest more growth to come due to the ageing population, the shift from final salary to defined contribution arrangements, and the beginning of auto-enrolment that will create many thousands more pension savers.
The introduction of the Open Market Option was a turning point for the annuity market. Before 1978, all pensions vested internally leaving the pension scheme member with no choice but to accept what their provider was offering. But with the OMO came the right for customers to take their pension funds to external providers if they offered a better deal.
Encouraging people to actually exercise that right has proved more difficult, prompting further reforms in 2002 forcing pension providers to inform their customers about the potential benefits of using the OMO. This remains a live issue and concern about low take up rates has persisted, particularly among those with smaller pension funds who are less likely to seek professional advice.
Still fewer than four in 10 actively shop around and those missing out are the ones who could benefit most from the extra income. From March 1st this year, pension companies who are members of the Association of British Insurers must adopt a new mandatory Code of Conduct on Retirement Choices that the organisation promises "will ensure that customers are equipped with the information they need to understand their options, shop around and make an informed decision about their income in retirement". The Financial Services Authority has also recently announced an investigation into whether some customers are losing out.
While OMO may not have been a unqualified success at an individual level, it did have a profound impact on the overall annuity market by introducing competition which in turn has sparked new innovation. Effectively it has encouraged the creation of new and better value products. Chief among these are annuities that offer higher incomes for those with health issues or with lifestyle factors that shorten life expectancy.
These date back to 1995 with the introduction of the first smoker's annuity and impaired-life plan, followed by postcode annuities within a few years. This has resulted in an increasing drive among providers to assess mortality using a spread of information, including lifestyle factors such as smoking and obesity, geographical area of residence, occupation or medical history or impairments.
From a standing start in the mid-90s, the enhanced annuity market has grown to be worth around £4 billion a year, a doubling in about three years.Despite this, it still accounts for fewer than one in four of the total annuities sold, giving continued scope for growth.
The market continues to grow in both size and sophistication, bringing in new competitors. The conventional players who dominated the compulsory purchase annuity market of the past have seen market share go to specialists such as Just Retirement, Partnership, LV= and MGM Advantage, with yet more providers likely to become involved.
The move to more personalised rates based on an individual's own health and lifestyle circumstances mean that the 'standard' annuity rates carried in the newspapers are no longer a good guide to the value a retiree may attain. The decision to ban gender pricing from the end of last year will hasten this move to more sophisticated pricing and will put pressure on some providers to either develop new underwriting capability or to strike deals with those who already have it.
At its heart, the growth of the enhanced market relies on underwriting. In order to boost efficiency and reduce hassle for buyers, providers worked together to create the Common Quotation Form and more recently an electronic version to ensure the data needed is captured in a format that allows quotes to be generated and compared. Our experience is that most customers purchasing annuities via financial intermediaries consider that taking their pension is a serious financial decision and understand - in fact, welcome - the opportunity to fully disclose information about their lives and health.
The quest for timely and accurate data has also led to the development of tele-underwriting services that put clients in contact with knowledgeable health professionals who improve information gathering.
Technology is driving the change by enabling us to gather and process additional information, more quickly than ever before. The more we know about the client, the more accurately the risk can be priced, resulting in fairer rates for clients and improved risk management for the provider. There is now real competition to be the provider with the best intellectual property based on superior understanding of life expectancy. Today we price on multiple factors, seeking to capture the interplay between medical conditions, lifestyles and treatments. The result is that enhanced annuity providers are developing niches of expertise and no one provider can offer the best rates for all conditions.
While the development of enhanced annuities has been mainly for individuals with their own funds, we are now seeing the concept being ported across into the bulk annuity market with the first medically underwritten buy-ins completed at a reported cost-saving of around 10 per cent compared to a non-underwritten solution.
This is a hugely important area going forward and the market remains in its infancy. Small and medium-sized schemes have not been well served by the market because they are not as lucrative as bigger schemes, but they have exactly the same need to de-risk at reasonable cost. Underwriting on health grounds is more likely to generate cost savings for more focused memberships than larger schemes where life expectancy will be closer to the average.
The key to the market is being able to work with trustees to gather the information on the members while keeping the workload and the intrusion to a minimum. In many cases a small number of members may well account for a relatively large chunk of the liabilities.
With opportunities in both the individual and corporate market, these are exciting times to be involved in facing up to the UK's retirement challenges. And no area is busier that the enhanced - perhaps better described as the 'personalised' - annuity market.
Stephen Lowe is the group external affairs and customer insight director of Just Retirement
