Variable annuities. Are they the answer-a genuine alternative to the good old conventional pension annuity? Are they the solution to end all at retirement solutions, the key to future profits…or a liability that could threaten the stability of life offices in choppy markets?

An annuity story from America. Credit analysts Fitch Ratings said that last month Old Mutual had to plough up to $70 million into capital reserves to cover unexpected costs across its US variable annuity product.

Analyst Harish Gohil said that the capital reserve bill is likely to have arisen from the insurer’s failure to predict the risks associated with guaranteeing the income of its variable annuity customers. It would appear that annuity providers have to be careful with this product.

UK insurers including Aegon and Standard Life are eager to grab a piece of the third way pie but mispricing the cost of the guarantees associated with these products throw up unwanted bills that could shake the foundations of UK and US insurers alike.

Is it a risk worth taking?

Why? Because more than 40 per cent of UK defined benefit schemes (final salary) are likely to be closed to future accrual within the next five to 10 years. This means that more and more people will have to rely on a pension annuity instead. This 40% figure would be a staggering increase from current levels, as only 6 per cent of defined benefit schemes are currently closed to future accrual.

The proportion of defined benefit schemes open to new entrants is also expected to fall to 4 per cent over the same period. Currently 25 per cent of schemes are open to new entrants. Again, leading to more people requiring pension annuities.

The market is seeing an increased focus on defined contribution provision instead. More than 60 per cent of employers predict that employer contribution rates to defined contribution plans would increase in the next five to 10 years.

Defined contribution plans now make up 75 per cent of open work-based pension plans, and on average the plans provide employer contributions worth 9.5 per cent of salary in return for employee contributions of 5.2 per cent.

The FSA is maintaining pressure on life companies to keep their literature free of jargon on pension annuities. One recent FSA investigation found that 4 in 10 annuity ‘wake-up’ packs - sent by insurers to savers close to retirement to explain how they could secure a bigger pension annuity - were confusing.

A ’significant number’ of firms failed to explain that calling up rival insurers to get a different quote could mean a bigger annual pension annuity, says Sarah Wilson, the FSA’s director for insurance, in a recent speech to the Institute for Economic Affairs. ‘Similarly, very few firms mentioned the advantages of shopping around for customers with health problems, who could be better off buying an annuity from providers offering “impaired life’” or “enhanced rate” annuities,’ she adds.

The FSA is due to publish its conclusions later this week into this issue and another - the alleged ‘delays’ in transferring annuity funds from one life company to another, which can leave savers out of pocket. Such delays could cost the annuitant hundreds, or thousands, of pounds a year.

‘When you’ve saved for your whole working life and your annuity choice comes down to one moment, we have to make sure that all customers have a clear understanding of what’s available,’ says an FSA spokesman.

Looking at annuity rates; at their peak in 1990, the best annuity rates hovered at around 16 per cent, this means you would get £16,000 a year for every £100,000 of a pension pot saved in a ‘defined contribution’ pension (as opposed to a final salary scheme, where the employer payout depends on your longevity at the firm and your pay).

But that was then, a predominantly high-inflation, high interest-rate period. Annuity rates then began a relentless downward march to less than 7 per cent in a fairly smooth trend - primarily as a result of falling yield rates and our rising longevity - but since early 2007 they have begun to rise significantly (see table, left). Early last year, the best annuity rates fluctuated at or around 6.92 per cent. Now they are nearer 7.85 per cent.

Prudential currently price individual annuities based on age, sex and fund size. Until recently, these pricing factors have been used across the industry, but this is now changing. From 11 August 2008 Prudential will be introducing Lifestyle Annuity Pricing to external Guaranteed Annuities. Lifestyle Annuity Pricing reflects the fact that a person/s lifestyle affects their mortality and that postcode can be used as an indicator for lifestyle (i.e. there is a strong link between postcode and diet, smoking habits, occupation, wealth and so on).

Through applying Lifestyle Annuity Pricing, those living in less affluent post code areas, where life expectancy is lower than average (other things being equal), will receive higher annuity income than those living in more affluent areas where life expectancy is higher than average. The introduction of postcode as a rating factor therefore will mean that some new annuitants (”less affluent postcodes”) may be better off compared to current annuity rates, and others (”more affluent postcodes”) may be worse off.

The introduction of Lifestyle Annuity Pricing is a key development for Prudential. Lifestyle Annuity Pricing is about bringing a fairer and more transparent solution to annuities pricing to the market and will benefit many customers. It very much supports their strategy of being a Leader in Retirement. 

The Association of British Insurers (ABI) has moved to improve awareness of annuity options among policyholders. It will distribute information to people who are nearing the age when they will give up work and are looking to secure a retirement income.

It is hoped that these will highlight the benefits of shopping around and the scope that this affords customers of boosting their retirement money.

Maggie Craig, the ABI’s director of life and savings, said: “We are determined to improve the experience of customers approaching retirement. This means ensuring they understand their options, including their right to shop around, so they can make an informed decision and letting them know where to go to get help.

“Buying an annuity is a once in a lifetime decision that can’t be changed, so it’s vital that customers are given appropriate help to make the right choices, and make the most of their retirement income.”