Every cloud has a silver lining

The Financial Services Authority (FSA) has just published a report Financing the Future: Mind the Gap. The message is clear and very familiar. As a nation we are living longer and will be spending more time in retirement, and we are not saving enough in general terms to ensure we have a decent income to fund these years.

When we hear people complaining about annuity returns being lower than they used to be, it is easy to see that it is not solely the result of a downturn in investment markets. It has as much, if not more, to do with the health ' and therefore life expectancy ' of older people in the UK.

The FSA report reveals some startling facts:

• By 2025, there will be only two people employed for each retired or inactive person over 50.

• By 2030, nearly 30% of the population will be aged over 60 ' an increase of around 20% on today.

• Life expectancy for men and women at birth is projected to increase from 45 and 49 years respectively in 1901, to 80 and 84 years in 2011.

The key theme here is that health has only improved in general terms. As we know from the long term care insurance market, we do not all live healthily for all our lives and then suddenly drift off into the bright blue yonder.

According to research from Ge Frankona Re, one in two Britons are likely to suffer a critical illness such as cancer or heart disease at some point in their life. And according to research conducted by Swiss Re Life, one in three males and one in four females are more likely to suffer from a critical illness before the age of 65.

Although many of those that contract a critical illness are cured well before their retirement age, many are not.

Many people have to endure a retirement that is cursed with problems associated with disability and illness ' physical or mental. And that is where the irony comes into play. For some people there is an upside which arises from poor health and it comes in the form of enhanced income in retirement, not at the point of crisis when residential nursing care is needing to be funded, but in the shape of a pension income.

Annuities are still an excellent means of protecting against longevity risks. However, it is still a gamble in that if you die earlier than expected then you might not get a good return on the capital invested. In fact, you might not even get your capital back. Therefore, if you know you are in poor health, or have a life expectancy significantly lower than average, then it may not be wise to take such a gamble. However, under the current regulatory regime you have little choice, as a pension fund has to be used to purchase an annuity by age 75.

This has always been one of the criticisms of the current pensions regime, but one which could be resolved by the underwriting of annuities.

Currently a healthy 60-year-old male annuitant would be expected to survive over 20 years and has a 10% chance of surviving over 30 years. For a 60- year-old male who has half this life expectancy ' they are expected to survive 10 years with only a 10% chance of surviving over 15 years ' then an enhanced annuity could give an considerably higher income.

Figues from Norwich Union state that an impaired income for this client would be boosted to £5,535, compared to £3,423 on a standard income.

Without the benefit of an impaired rating the individual would only be expected to get a total of £34,230 back in income from a £50,000 premium and there is only a 10% chance they would get back more than they paid in. Using impaired life annuities there is a considerably better chance that all the invested capital would be returned.

Of course there is still the chance, as with any annuity, that the annuitant could die soon after taking the policy out. Unfortunately it is not possible to fully protect against such events, and in fact early deaths are part of the whole concept of 'pooling of mortality' which enables the annuity provider to give higher annuity rates.

As well as using medical conditions to underwrite annuities, it is also possible to look at various lifestyle factors to rate annuitants.

Underwriting annuities

Conventional annuities usually only take three factors into account: age, gender, and a guaranteed payment period. The first form of distinction that an underwriter or pricing actuary might take into account is whether smoking or non-smoking terms apply. There can be quite a difference in the income generated.

According to MoneyFacts, the top standard rate on an annuity with a £10,000 premium for a 60-year-old male is £721.65, whereas the top smoker rate is £785.52. For a female of the same age, the top standard rate is £680.64, with the top smoker rate standing at £736.92.

A smoker can gain an additional 10% on an annuity over a non-smoker. This enhancement is less than the difference in term assurance rates, where smoker premiums can be double the non-smoker rate. The reason for this is that the impact of smoking on life expectancy reduces with age, especially after age 60.

Over time we could see more general use of underwriting in pricing annuities. Some companies might already consider the postcode of the annuitant when setting rates, with there being ample evidence that life expectancy can vary between one part of the country and another (see table).

Given the obvious differences in health and lifestyle between different regions, there is no reason why location ' along with other factors such as occupation ' could not eventually be a standard underwriting factor used to rate annuities and giving enhanced terms. However, this might mean offering lower rates for others, but providing the terms that truly reflect the life expectancy of individual annuities, it would still provide excellent value for money.

Maximising choice

The FSA and the Association of British Insurers have been keen to ensure people approaching retirement maximise their choices. Now it is compulsory for pensions offices to alert their customers to the benefits of exercising an open market option, rather than going with the flow and purchasing their annuity from their existing pension provider.

Large differences exist in annuity payments between one office and another. Most individuals will have relatively little knowledge on matters such as impaired life annuities. There is a significant role for the adviser who might have helped them with health problems during work, to also ensure those same clients secure the best deal when it comes to their income in retirement.

In the past year or so, significant growth and interest has manifested itself in the impaired life market as a means of funding care fees for older people. There is a growing recognition in the minds of people approaching retirement that they need to maximise their income thoughout retirement. Similarly, there has been a growing recognition by providers that they need to offer as wide a range of options to meet that demand. The retirement market as a whole is going through radical change and it now seems right that impaired life annuities are pushed to the forefront of product development.

Sandy Johnstone is retirement and protection strategy manager at Norwich Union