From next April, pensioners will be able to sell their annuity to a third party in exchange for a lump sum. Can we expect a secondary annuities market to take off? Lynn Strongin Dodds finds out.
“A secondary market could create the same moral hazards seen in the US life settlement industry. When designing the rules policymakers must be cognisant of the conduct issues because they can blight the market if it emerges.”
Douglas Anderson
Despite the debate and discussion about the creation of a secondary annuities market, industry participants are skeptical that it will see the light of day. Educating investors and valuing contracts will present hurdles, but more importantly a change of government may see the proposal pushed to the back or off the agenda.
For now, it is in the consultation stages and follows on from the radical reforms introduced by the coalition government in 2014 which aimed to give five million pensioners greater choice. Staring next April they will be able to sell their annuity income to a third party in exchange for a lump sum or an alternative retirement product. A secondary market would offer them the chance to sell their income to the highest bidder – a pension fund or insurer company – although not the firm that sold them the original contract.
The devil, of course, is in the detail and the annuity’s ‘resale value’ won’t be formulated on the original purchase price less instalments received. Instead, it will be based on the buyer’s view of the sustainability of the payments – the health of the individual as well as the investment yields – at the time of purchase as well as into the future.
It is still unclear what advice and consumer protections would be implemented. The government said it will work with the Financial Conduct Authority (FCA) but potential safeguards being mooted include a requirement for the annuity holder to take regulated advice before selling, similar to the existing requirement that applies to transferring savings from a defined benefit to a defined contribution scheme. The government said that although this advice could be expensive, “recent clarification” by the FCA rules around simplified advice could potentially create a new type of advice product.
THE COST OF FREEDOM
In addition, it could also expand the remit of the government-backed Pension Wise independent guidance service to cover annuity re-sales, or including appropriate risk warnings in the information that providers are required to give savers. The big question though is whether pensioners will be willing to pay for the advice and if not, what type of decisions will they make.
To date, the appetite for offloading contracts is small, with around 33% of the 1800 annuity holders surveyed by investment and financial planning firm Tilney Bestinvest indicating they would keep their contract while 50% were undecided. The remaining 17% said they would consider selling. While the report did not divulge any concrete numbers, it noted that the costs of developing a secondary market including advice, infrastructure, technology and underwriting could run into the thousands.
A study published in April by the independent research group, the Institute of Fiscal Studies (IFS), was also bearish on its future prospects. It noted that although a secondary market provided a “welcome liberalisation of the market and was perhaps a natural next step” following the last year’s Budget’s retirement changes, there were risks involved.
The most notable is adverse selection, which is a well-known term in the insurance vernacular that means low quality prospects drive out better investments. In this case the pensioners most eager to sell their lifetime income will be those with the shortest expected lifespan while those who believe they have longer to live will be less willing to part with their annuity.
UNEVEN OUTCOMES
In addition, the report noted that a significant minority of annuity holders – in particular, older annuity holders – may struggle with the complex decisions required in valuing their annuity compared to an alternative lump sum.
Moreover according to Gemma Tetlow, senior researcher at the IFS, on average women live longer than men, but it may well be illegal for purchasers to offer prices that vary by sex, meaning that the resulting market will be particularly unattractive to women. Individuals may also have better information about their survival chances than potential purchasers can hope to extract.
In the report, Tetlow notes, “valuing an annuity versus a lump sum is a complex calculation and requires people to grapple with uncertainty surrounding their own longevity, potential future investment returns and inflation. Therefore, a further concern with this policy might be that some annuity holders are not well-placed to make such decisions and may – as a result of this policy change – make a choice that is to their detriment”.
She concluded that part of the animosity towards the old ‘compulsory annuitisation’ requirement was driven by a “not always well-evidenced” belief that annuities offered poor value for money. “If the market for selling annuities was perceived not to work well, it is far from clear why a market for buying them back should work much better,” she says.
USING YOUR OPTIONS
Market participants echo these concerns.
“This will be an appealing policy to many pensioners who feel trapped in a product they didn’t want to buy,” says Douglas Anderson, partner at Hymans Robertson.
“However, individuals need to carefully consider giving up their annuities,” he adds. “If you’re looking for a guaranteed income to last your life then an annuity is hard to beat. Our research shows that women underestimate life expectancy by eight years and men by five years. This gap between the perception and reality could have significant consequences in the context of this proposed reform. Annuities have had a bad press, but for many they are a good, if under-appreciated, option.”
A LESSON FROM AMERICA
Anderson also warns that a secondary market could “create the same moral hazards seen in the US life settlement industry. When designing the rules policymakers must be cognisant of the conduct issues because they can blight the market if it emerges.” Major medical underwriting firms significantly changed their processes which resulted in an increase in projected life expectancies. This meant that the promised double-digit returns of 10% to 11% were whittled down to 3% to 4%.
Research from Hymans Robertson notes that the big difference between an annuity and an endowment policy is that the health of the individual has a considerable impact on the value of the annuity. For example, the value of an annuity for a 70-year-old with a terminal illness will be substantially less than the value the same annuity for a healthy individual.
Alex Waite, head of LCP corporate consulting, also refers to what behavioural economists call the endowment effect, which means that people place a higher value on things that they own relative to objects they do not.
He explains: “Although people are showing interest, take-up is likely to be small because individuals do not want to give up the pool of money they have. There are also better opportunities for those in late middle age to access immediate cash, such as taking out a loan in this low interest rate market.
“For these reasons the secondary annuities market will need a serious push from government to get moving. Whether the next government will be keen to do this remains to be seen, but my view is that a Conservative [government] is more likely to take action.”
LACK OF APPETITE
Jamie Jenkins, head of pensions strategy, Standard Life also believes there is lack of demand for a large market.
Jenkins says: “Overall there are inherent problems with the idea and I do not think people will have the appetite. Firstly, a wholesale shift away from existing guaranteed income streams towards cash sums could have an adverse effect on people’s standard of living in retirement.”
In short, says Jenkins, if it led to people spending what was a significant proportion of their retirement income in one go, then it could lead to much wider problems.
“Such a proposal should be very carefully considered and the social and practical implications worked through in detail before any commitment is made,” he adds. “As for the secondary market, one of the fundamental issues is that there will be a misalignment between buyers and sellers. In order to get an attractive deal people will need to be in good health and income but they are unlikely to be the ones that sell. It will be those in poor health and they will not get a good deal.
“There will also be frictional costs as there will need to be third-party providers and I do not think they will buy anyone’s annuity without underwriting a new contract.”
Helen Forrest, policy lead for DB at the National Association of Pension Funds echoes concerns over inertia, pricing and underwriting costs.
She says: “I do think the election outcome could throw a spanner in the works but even if it does happen, the question is whether establishing the infrastructure required to develop a secondary market will be justified. There are a limited number of contracts and not everyone will sell so a secondary market may not be sustainable.”
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