Some people in the industry, like Lincoln Retirement Income, believe that traditional pension annuities, with their limited choices and inflexible rules, will become a thing of the past. Today’s clients demand and deserve a much more flexible solution, to let them enjoy their retirement in their own time and on their own terms.

A new plan has been launched to reflect this, the Lincoln i2Live plan. It is a flexible retirement plan that provides with: a unique Income Guarantee Option;  investment choice, regardless of age and taking an income;  flexible death benefits for dependants;  the opportunity to select and vary income;  and consolidate pension assets all in one plan to create an overall income strategy (currently excluding Protected Rights).

There are phased retirement options, and one annual statement for all aspects of their Lincoln i2 Live income plan. They claim it is one plan with many options.

Lincoln i2Live combines three retirement planning products in one arrangement. Depending on their needs and circumstances, clients can select an individual product or allocate funds between them at no additional cost, offering control over their financial future; known as:

i2Live Accumulator®: personal pension 
i2Live Drawdown®: income drawdown
i2Live Annuity®: flexible unit-linked annuity

Another insurance company coming in with a flexible annuity product. What we really need is a major UK insurer to get their product launched to stimulate interest in the domestic market.

Here we consider the benefits of pension annuities and why income drawdown should be approached with caution. There really is no argument to suggest that income drawdown will eventually replace pension annuities, although there is a role for income drawdown and variable annuities for the right customer at the right time.

Let’s consider annuitisation. It can work within pension annuities invested in unitised funds thereby enabling a higher lifetime income in exchange for giving up capital on death. There is therefore no suggestion that income drawdown will replace pension annuities simply because drawdown can invest in equities and enjoy the benefit of the equity risk premium.

The critical difference between annuities and drawdown is the impact that annuitisation has on the trade-off between income and death benefits. Higher death benefits result in lower income and vice versa - you can’t magic something out of nothing or magic the risk away.

One major reason why drawdown will not replace annuities is the size of pension funds. Too many are too small; over 75% of current funds are less than £30,000 after the 25% tax free cash has been taken. 

Hopefully, fund sizes will increase significantly in the future and this may lead to higher drawdown take up. But there are always going to be a lot of pensioners with insufficient funds to be able to afford the drawdown route, and who will get better value from buying a new generation pension annuity product.

Generous, Government, tax…not a combination you’d expect. However, pension annuities are an integral part of a generous UK pensions tax regime. On balance it is perhaps therefore not unreasonable for the Government to expect annuitisation of 75% of the fund, i.e. after the 25% tax free cash element.

The benefit of annuitisation at age 65 is relatively small. The chance of dying at age 65 is less than 1%. An annuitant receives a mortality cross subsidy of less than £500 in that first year for putting £50,000 capital at risk. This is not very attractive and does not lead to a significant increase in lifetime income. Most pensioners would rather retain control of their capital.

As you would expect, as people get older so the benefits of fully annuitising grow exponentially and the impact of investment returns diminishes. Let’s delay annuitisation to 85…a male aged 85 deciding to annuitise today with no death benefit, the pension annuity would provide a guaranteed income of around 20% of the capital (healthy). The mortality cross-subsidy overshadows any investment return, so fixed pension annuities with their bond investments increasing, become the optimal solution.

It is not a question of if but when pensioners should fully annuitise; remembering that this is not necessarily when the pension annuity is first purchased. Pensioners need a retirement annuity account which limits the fund at risk in early years but retains mortality cross-subsidy in later years to provide the essential longevity insurance. 

Pension annuities have a central role as part of any retirement income plan and offer the most effective and economic way of maximising lifetime income, with a guarantee.

Pensioners using income drawdown as an alternative to a pension annuity are exposed to a number of risks:

- they risk outliving their capital, or more likely having to reduce their income as they get older

- they are exposed to investment risk such as drawing down income when markets are depressed, which can have a significant impact on overall income levels

- they are exposed to the risk when they decide to purchase a pension annuity

- they expose themselves to ‘mortality drag’ and the risk that mortality improvement assumptions will be strengthened by the time they come to switch to a pension annuity.

Of course these risks can work in a retirees’ favour, but the key point is that only those who can afford to take these risks should do so. Given the lack of adequate pension savings this is unlikely to be a majority. This backs up the point that pension annuities are likely to be the right choice for the majority of people reaching retirement.

It now looks as though Norwich Union, already a major player in the pension annuity market place, is ready to follow its competitors into the variable annuity market next year. Head of investment development Andrew Lee says the life office is “ratcheting up” its interest in third-way products and has increased the number of staff studying the sector. This could well lead to them offering a new product in 2009.

He says: “We are conscious that the products meet a consumer need to have more certainty and piece of mind but we are also conscious of the price issue. UK consumers are more price-conscious than in the US. Current economic conditions are likely to increase consumer appetite for the products. Several insurance companies have been caught out by their own assumptions so they will be very careful that their capital preservation ensures that these products do not come back to bite them. This is something that plays to our core strengths.”

Interestingly, both Standard Life and Prudential recently announced that there variable annuity offerings are being delayed. Aegon has recently launched a guaranteed offering and Axa is set to launch next year.

For these new variable annuity style products to capture the consumers imagination it would be good for a major player such as Norwich Union to come into the sector as it could mean that this market is finally starting to mature.

Certainly products to date, mainly from US providers, have not yet caught on, and are still seen as complicated and expensive. 

Variable annuities, the subject of recent press reports, have the potential for creating a mismatch in the advice given to clients which could result in some clients being unwittingly placed at a significant disadvantage. 

‘Variable annuities’ is an American term for income drawdown products with in-built guarantees. In the UK these have become known as ‘third way’ pensions. In many cases, the extra cost of providing the income guarantee is not worth paying for unless the client actually needs it. Typically, the cost of this guarantee is around 0.75% to 1% of the fund per annum. 

Prospective investors may not fully appreciate the long term impact when the benefits are being explained to them, and there is hope that the FSA keeps a close track on how these plans are being recommended. 

‘Third way’ products definitely have their place, but the product providers in this space will be the first to agree they are certainly not a cure-all for the ‘at retirement’ market.