Why annuities switching is likely to cause serious problems for UK insurers

Philip Booth
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WE HAVE little detail of pensions minister Steve Webb’s proposals to allow pensioners to switch between annuity providers in the same way that they can switch between mortgages. However, at first sight, his ideas provide more evidence that the coalition made a serious error in appointing somebody so far to the political left to such an important role.

He looks to have been left unscrutinised on the ground that pensions policy is simply a technical matter that can be safely handled by a clever minister, regardless of his underlying political philosophy. But allowing people receiving annuities to change provider in mid-stream would have profound implications for the market.

Imagine a situation where someone retiring today could buy an annuity of £5,000 per annum for £100,000 based on an interest rate of 3.5 per cent. To simplify the situation a little, the insurer would then invest in securities that would provide the required return over the life expectancy of the annuitant. What would happen if annuity prices fell because interest rates rose? It seems Webb would like to allow the annuitant to leave the insurer and obtain a bigger annuity payment based on the new higher levels of interest rates from a different insurer. The original insurance company would have to sell the securities – which would have fallen in value because of the rise in interest rates – at a loss.

A similar situation would arise if the annuitant’s health deteriorated. He or she could leave the first insurer and get a better rate elsewhere, leaving the original insurer with those customers who are likely to live longest.

Webb’s proposal, if implemented in the way he has implied, would make it compulsory for insurers to adopt business plans rather like those of the Equitable Life before its demise. Just as the Equitable (which made one of the largest business errors in the history of UK life insurance) gave customers the option to take an annuity or a cash sum depending on financial conditions, these proposals seem to suggest that customers should be able to move their policy if their health changed or if there was a rise in interest rates. This would be to their own financial advantage, but to the disadvantage of the annuity provider.

It is possible that Webb only wishes to bring in transferable annuities as an option. But it’s not impossible to sell such products already. However, it would be very expensive for a company to do so, as the annuities would need backing by complex financial instruments. One actuary has estimated that a transferable annuity would deliver 25 per cent less income than a standard annuity. It is hardly surprising that the market is not thriving.

If customers wish to have more options over investment returns when buying an annuity, there are already products that provide such flexibility. Similarly, because of recent reforms, those who do not wish to splash all their cash on an annuity because they might die earlier than the average person can now more easily avoid doing so. Perhaps significantly, these changes were not put through Parliament by Webb, but by the Treasury.

Philip Booth is professor of insurance and risk management at Cass Business School, and editorial and programme director at the Institute of Economic Affairs.