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Category Life Insurance

In praise of some traditional annuities

03 December 2007 Foord Asset Management

Retirement savings products have been the subject of much attention over the last while. The life industry, the Pension Funds Adjudicator and the government have locked horns. By and large, this storm seems to have subsided. However, one should question whether the same scrutiny shouldn’t be lavished on the products that are relevant post-retirement.

Annuities are an essential component of one’s ultimate retirement plan. Compulsory savings (those accrued in vehicles such as retirement annuities) have to be used to purchase an annuity to provide an income during retirement.

There are two broad kinds of annuities: living annuities and traditional annuities (included in this group are guaranteed annuities, with profit annuities and increasing annuities).

Living annuities have received much attention in the financial press. These products have increased in popularity over the last few years. Certainly, at least some of this popularity is warranted: living annuities afford the retiring investor (either alone or in consultation with a financial advisor) the discretion to determine the strategy of the investment portfolio that provides the living annuity. Furthermore, the living annuity also allows the annuitant to determine the amount of the annuity, which amount can range from 2.5% to 17.5% of the invested capital. Also, if the annuitant dies before the capital is exhausted, that capital passes to the annuitant’s beneficiaries.

Of course, these obvious benefits are not without their price and risk. In the first instance, the onus to maintain sufficient capital to last for the remaining life of the annuitant rests with the annuitant, not the institution who provides and administers the living annuity. The stellar market returns of the last few years may have blinded some annuitants to this risk.

Secondly, an inappropriate investment strategy (whether self-chosen or advised) may result in poor returns or worse, the erosion of capital such that the amount of the annuity drawn from the portfolio must reduce, so decreasing the annuitant’s standard of living.

Thirdly, the eroding effect of costs and commissions on living annuities can be material. If one is obtaining advice regarding the investment of the living annuity portfolio, then one cannot deny the adviser some form of remuneration. Typically, the adviser receives an upfront commission and an ongoing “trail” commission, both of which tend to be calculated as a percentage of the asset base. Without being drawn into the debate regarding how advisers should be remunerated, it cannot be disputed that these costs can and do erode returns. Furthermore, alterations in the constitution of the investment portfolio inevitably result in administration and “switching” fees, which further erode returns.

Finally, living annuities have tended to be utilized by more affluent annuitants with more considerable retirement savings who may (but not necessarily do) have a greater tolerance for investment risk. Annuitants with more modest retirement savings tend to have more limited choice – typically, such annuitants find themselves in the traditional annuity space by default.

Traditional annuities may be described as less complicated than living annuities. The annuitant, who has accumulated an amount of money in retirement savings, pays that sum over to a life company in exchange for a regular income payable until the death of the annuitant.

Of course, there are a myriad of variations of this simple concept. For example, traditional annuities may be guaranteed for a certain minimum period, even if the annuitant dies during that period. They may also make provision for the continued payment of the annuity until the death of a surviving spouse. Some, called “with-profit annuities”, give the annuitant the potential benefit of an increase in income if the returns on the annuity portfolio are appreciable (but largely because of their complexity, these “with-profit” annuities have fallen out of favour). In essence, though, the concept remains as described in the previous paragraph.

The annuitant assumes no “mortality risk” (the risk of outliving one’s savings): the life company’s actuaries estimate the remaining life of the annuitant and pay an annuity taking this important factor into consideration.

Also, the annuitant has no role in the determination of the underlying investment strategy. It is the life company’s prerogative to invest the funds as they see fit, with the clear understanding that these funds must provide sufficient return to continue funding the annuity. Where such returns are not forthcoming or capital becomes too eroded, the life company’s shareholders must inject capital to support the annuity portfolio.

Furthermore, traditional annuities, once bought, require no further input of administration on the part of the adviser. Consequently, commissions for these products tend to be upfront only, with no “trail” fee. Again, there is some debate as to the appropriate quantum of commission payable to advisers on these simple products.

In managing the risks that they assume by paying guaranteed annuities, life companies have adopted certain strategies. Essentially, to minimize investment risk, life companies invest the assets of the annuity portfolio in fixed income securities. As a consequence of this, less of the shareholder’s capital is put at risk (and so it can be deployed in other, possibly more lucrative, avenues); however, it also means that the annuities paid are largely a function of the risk free rate.

So where does this leave the customer who doesn’t have sufficient wealth to make a living annuity viable, but who would also prefer to have the best possible alternative?

I’d suggest that something of a revolution is required, and perhaps a “new generation” life company should come to the fore to provide an enhanced annuity product for those investors who can’t or won’t use a living annuity, but who need a secure income for life.

This new generation life company should have three key ingredients: a low, efficient cost structure, sufficient capital, and a proven successful investment aptitude.

Firstly, low costs means less cost recovery from products and clients, and so more of the annuitant’s capital can be invested and so enhance the amount payable as an annuity. A simple, understandable product set is less costly to administrate and it would assist clients in making appropriate and beneficial decision.

Secondly, having sufficient capital that shareholders are prepared to invest in supporting the annuity portfolio gives annuitants confidence that their incomes are assured; also, sufficient capital allows the life company to pursue carefully considered investment strategies that go beyond fixed income portfolios and cash flow matching.

Thirdly, proven investment acumen, when applied in a well thought out and appropriate manner to the annuity portfolio, may allow the life company to offer superior annuities to clients, so enhancing the potential future incomes, and consequently, quality of life, of those clients.

These ingredients are not ethereal – they already exist. And so it is just a question of time before such valuable offering in the traditional annuity space becomes a reality. At Foord, we’d like to think that it will happen sooner rather than later.

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