UK abandons annuities – where now for retirement income?

Imagine if in the May Federal Budget the Treasurer announced that super was no longer compulsory.

The UK has just seen something comparable with the overnight abandonment of compulsory annuitisation at retirement.  With Australian super funds getting to grips with retirement income, valuable lessons can be learnt.

Unlike in Australia where retirees are free to take their benefit as a lump sum, drawdown, allocated pension, or annuity, the UK has forced their retirees to purchase an annuity with most of their fund balance (or face punitive tax rates).

But all has not been well in the UK annuity market for some time – which we wrote about 2 years ago here.

With interest rates near nil, annuity returns are abysmal, effectively forcing retirees to buy bonds at the very top of the market, when much better yields are available elsewhere.  Other concerns include:

– High margins achieved by insurers where retirees rolled over to the default provider.
– Lack of competition.
– Lack of flexibility.
– Complexity.

Many of the issues we see in super around vertical integration, flipping, inertia, complex products, and limitations on competition, turned out to also be present in the annuities market.

Concerns have only grown since, leading the UK’s equivalent of ASIC to declare the annuities market as “disorderly”.  Clearly, the UK government elected to move straight to drastic reform.  The policy change has a familar (to Australians anyway) undercurrent that as the UK moves from defined benefits towards a defined contribution (DC) system, fund members should be in control of their retirements and allowed to invest as they see fit.

That is radical reform.  And for Australian super funds, it’s something of a cold shower for those assuming they need to invest heavily in guaranteed retirement income products.  What should we take from it?

The first point will be how the market responds to the removal of compulsion, which will reveal the natural level of demand for annuities.  Initial forecasts were not positive: a 75-90% decline in annuity sales being a typical estimate.  The market took this badly – share prices of specialist annuity providers fell in half, and even large diversified insurers fell 5-10%.

That said, care should be taken in interpreting this:

– Many annuities were being funded by balances of under $50,000 – too small for an efficient retirement income – small balances should never have been annuitized in the first place.

– The market reaction says that annuities are a hard product to sell in the absence of compulsion.  But that is probably also true of super too – it would not be a $1.5tn industry without compulsion, that’s for sure.  It doesn’t necessarily mean either is a bad product – just that most people don’t really want to save for retirement or buy longevity protection.

So what is the answer?  Looking at the UK market reaction, it thinks the winners are platforms and asset managers – share prices of listed players such as Hargreaves Lansdowne, Schroders, and Henderson all rose.  In other words, non-guaranteed personal income products and solutions.

With UK DC members now having the option to cash out, the practical issue for the product manager is this – given that my members no longer have to buy an annuity, what should the default design of my pension division look like?

This is the same question facing Australian super funds.  Retirement income has been seen as unfinished business from the Super System Review, and APRA has signaled its expectations that funds will develop solutions which address the well-known issues, including longevity and sequencing risk.

Answers are – literally – in development, and unusually, the Australian and UK pension industries are roughly in parallel.

Within the structures available (keeping in mind that the FSI might add to or change these), we have an opportunity to design something new.   In DC systems, members like being in control, and they’re used to investment choices, the ups and downs of market returns, and paying something every year for death protection.  Those features have the potential to be repackaged to create more flexible and marketable retirement income products.

But as ever, much will depend on the interaction with the tax and social security systems – a poor design with tax and / or social security advantages will outsell a good design every time.