Better informed customers and advisers will contribute to the rise in annuity sales, says Martin Langjkaer
During the past 15 years annuity rates have fallen by around 50% due to low interest rates and much higher life expectancies at retirement. This has driven a competitive industry to find ways of increasing pension payments in a conventional annuity market worth an annual £6bn.
The two main methods have been to increase investment returns via mechanisms such as income drawdown or to reduce the average life expectancy assumption via impaired life annuities.
The first strategy is riskier from a policyholder's point of view, as recent volatility in stock markets has shown. Even allowing for good investment performance, delaying investing until the maximum age of 75 will not necessarily lead to better returns. This is since the benefit of mortality pooling is lost during the delay. This phenomenon is known as the mortality drag.
As a consequence, impaired life annuities for those in poorer health are a much less risky and more satisfactory solution. By fulfilling criteria such as regularly smoking or a history of diabetes, a retiree could increase their pension by around 10%-20%. With more serious impairments, the enhancement could be upwards of 75%.
Although there are no hard figures on the take-up of impaired life annuities, analysts have estimated it to be as much as 10% of the conventional annuity market. So what will drive further take-up?
• Better informed consumers. Only a third of policyholders exercise their open market option and shop around at retirement to maximise annuity income. From 1 September 2002, the Financial Services Authority will require firms to raise policyholder awareness of this option. This will increase the potential market for impaired life annuities.
• More household names. Household names in the traditional market arguably benefit from the large proportion of retired people not shopping around. By offering both impaired and standard annuities, a household player would be removing the cross subsidy of unhealthy lives to healthy lives, leading to a reduction in their standard rates and reduce their competitiveness.
• Growing competition. Niche players that cherry-pick impaired lives will eventually lead to reduced standard rates in order to restore margins. Newer market entrants, such as Prudential, may indicate that this may be happening already. Brand awareness will then encourage further take-up.
• More impaired classes. Each new entrant is likely to develop slightly different rating criteria leading to many classes of impaired life as has already happened in the US preferred life market. Ultimately this may mean one small class of super-healthy standard annuitants and hundreds of impaired classes.
• Better informed brokers. Brokers with more time available to maximise annuities for clients will be faced with products with clearer rules regarding what qualifies as an impaired life, making placement easier.
• Government pressure. The Government is keen to keep annuities as the standard retirement vehicle, but to ensure greater value for money and encourage innovation.
Although growth of impaired life annuities in recent years has been impressive, it is likely that the market is nowhere near its maximum potential.
