Pensions minister Steve Webb has started the year with a bang by announcing he wants to allow those who purchase an annuity to be able to switch to another provider if they find a better deal.
In the same way that individuals can switch their mortgages if rates change, Webb wants to give people who take an annuity the option to break out of their contract and switch provider, which would enable them to access potentially better rates, especially if their health sharply deteriorates.
Speaking to the Sunday Telegraph, he said: “Why shouldn’t you be able to change your annuity provider so a few years later somebody else could offer you a bigger pension? Why shouldn’t you be able to shop around?”
Buying an annuity is probably the biggest single financial commitment an individual will ever make and I don’t think anyone would argue against trying to give retirees a better deal, including the Financial Services Consumer Panel which concluded late last year the annuity market was a “lottery for consumers”. However, in practice Webb’s idea leaves much to be desired.
There is a risk that if providers began offering, say, a guaranteed lifetime annuity with a transfer value option that someone can exercise then this would have to be priced in, which not only is difficult to do correctly but could even result in reduced annuity prices – industry figures have estimated up to 25% lower in some cases. What if this was to eventually lead to annuity providers unable to offer annuities profitably and closing down? What would then happen to policyholders? Surely this is not what the minister wants?
Furthermore, on the investment side with gilt yields so low insurers are increasingly turning to illiquid, long-dated social projects and infrastructure-type assets. However, they would be forced to change this mindset if they had to be able to access money overnight when a member wanted to switch provider, thus jeopardising investment in these important and worthwhile social projects.
Perhaps the only group welcoming an annuity switching market is the banks that would be called upon to create financial hedging products, such as interest rate put options, which insurers would have to buy in order to protect themselves against rising rates.
Rather than further complicate the system and deter product and investment innovation from insurers, the focus should be on optimising defined contribution (DC) scheme design and allowing each and every retiree to shop around using the open market option so that they get the best possible annuity for their circumstances up front.
As more and more people enter DC schemes after auto-enrolment, default fund design needs to be sophisticated enough to deliver the best possible pension pot at retirement. This involves mixing an adequate level of growth during accumulation with sufficient downside protection, while keeping an eye on cost for the member.
So the challenge in 2014, as it was in 2013 and long before then, is for DC providers and asset managers to push the boundaries at both the pre- and post-retirement level to improve member outcomes all round. But of course, the industry can only do so much and its efforts could be in vain unless members themselves start making adequate contributions into their schemes. Here’s hoping auto-enrolment will facilitate a change all round.
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