Pensions minister Steve Webb recently called for retirees to be able to cash in or swap annuity providers in much the same way homeowners can currently switch their mortgage rate.
This is a natural extension to the freedoms afforded to pensions from April this year when the requirement to annuitise will be eliminated.
The proposal to allow the cashing-in of annuities seeks to address the concerns of the 5m individuals who have already used their retirement pot to buy an annuity, prior to Osborne’s Budget announcement.
It also would help tackle the perennial problem of individuals who failed to shop around when purchasing an annuity and subsequently found themselves locked into a poor-value product.
But what would a secondary market for annuities look like for the individual? Would flexibility provide a better deal? And how would it be regulated?
These are all areas yet to be addressed.
Future retirees might like the idea of an annuity where they are not locked in for life, either in relation to the term of the annuity or the rate paid.
The idea is likely to be more viable for future annuities rather than breaking existing annuity contracts, as the features can be priced in
However, most individuals would likely benefit from sticking with their existing, guaranteed income annuity.
Improved flexibility would potentially only be met by a reduced annuity term and/or a lower rate paid, as insurers will have limited ability to invest in higher-yielding, illiquid and longer-term assets.
As with other changes in recent pension freedoms, flexible annuities would also drive up the need for advice to ensure individuals understood all income and tax consequences.
Who would buy it?
The most likely buyer of existing annuities would be the original annuity writer.
These buyers are unlikely to purchase an annuity product without a haircut of more than 20 per cent in embedded value.
This would account for shorter-term investment strategies, intermediation costs to purchase the annuities and the admin involved to value such policies – again, compromising income potential to the annuitant.
There are benefits to the annuitant, of course.
The Financial Conduct Authority is already undertaking a review into annuity transparency of charges and commissions as well as distribution.
Flexible annuities might assist in achieving these objectives, while also being much more transparent around terms.
A standardised annuity product, that would likely be the outcome of creating a tradable instrument, would certainly be desired in the wake of various product mis-selling cases in the retail space.
A missing piece of the pension reform jigsaw?
Overall, the idea of introducing flexibility into annuities, either for existing or future contracts, is a rational extension of recent government policy around pension freedom.
It is one solution in trying to tackle the problem that individuals do not like about annuities – being locked in, and at today’s low interest rates.
The idea, however, is likely to be more viable for future annuities rather than breaking existing annuity contracts, as the features can be priced in.
Annuitants will need to understand they are likely to receive a lower income on flexible annuities, unless a new class of investor emerges that has lower capital costs or can achieve higher investment returns than current insurers.
Either way, products with flexible features are likely to emerge to resolve the current conundrum.
The history of innovation in financial markets suggests that given this current need, a solution will emerge even if many challenges exist in bringing it to the fore.
Andrew Power is a partner at consultancy Deloitte
