US style Variable Annuities

In the US, variable annuities are tax-deferred savings plans. There is no tax on investment gains but tax is payable on the income payments. They have two stages: the accumulation period and the payout period when investors can take income by way of an immediate annuity, (for life or for a specific period), as a single lump-sum amount or through systematic withdrawals.

At retirement most investors choose between taking a lump sum payment (which is heavily taxed), or taking systematic withdrawals which is similar to our drawdown.

It would seem that many US investors and advisers have the same concerns about the risk of systematic withdrawals as we do in the UK. This was particular evident when stockmarkets worldwide fell in value from 2000 onwards.

New Guaranteed Income Products

In response to these concerns, many variable annuities started to introduce a “Guaranteed Lifetime Withdrawal Benefit” option. The guaranteed lifetime income is payable regardless of investment returns and most contracts lock in investments gains annually. Therefore investors can benefit from a guaranteed income for life without actually buying an annuity. In addition, if the fund increases in value, the level of income will increase, but if the fund value falls the income will be remain at the level at the last lock in. On death, the funds can be paid as a lump sum to beneficiaries.

The guarantee is provided by the insurance company through a process known as dynamic hedging and the underlying derivatives required to back these guarantees are rocket-science material. The cost of providing these guarantees is normally taken as an additional fund management charge.

The rationale for Guaranteed Drawdown

I believe the rationale for these new guaranteed annuity options is sound. After all many “Middle Britain” are saying that they don’t want to buy an annuities because if they die early they will lose the capital, but they are also uncomfortable investing in higher risk drawdown plans.

In short they want the best of both worlds; secure income as well as flexibility and investment control. That is exactly what guaranteed drawdown aims to provide.

New Products for the UK market

There are now several products in the UK that can provide a guaranteed income from a pension drawdown plan and these include:

• Hartford - GRIP
• Lincoln - i2Live
• Met Life

The Costs

There is a price to pay to for the lifetime income guarantee and this is represented by an increased fund management charge. Charges differ from company to company but typically range from 0.75% per annum to 1.5% per annum. The costs are lower for other guarantees such as capital only.

Most of the criticism is levelled at the charges. The extra annual management charges eats away at investment returns and in a bull market a naked fund will perform better than a protected fund. But in a falling market the guarantees come into play and the extra cost of the guarantee would have been a price worth paying.

Despite the obvious advantages, some commentators say that while investors may be getting peace of mind they may also be buying something they don't really need at an extra cost. But this is the case with all types of insurance. Supporters of these new products point out that we are happy to pay the cost of house insurance against the small risk that out house burns down, so investors should seriously consider paying an insurance premium against the very real risk that the value of a drawdown funs will fall.

Conclusion

Guaranteed drawdown gives investors the best of both worlds; guaranteed income and flexibility, including the option to change the level of income, control of investments and choice of death benefits including a lump sum (less a tax charge). But this comes with a cost and so investors and their advisers will have to carefully weigh up the advantages and disadvantages.

One of the reasons why lifetime income guarantees resonate strongly with many investors in the US is because they provide longevity insurance without requiring annuitization. In the UK context this means that investors can benefit from annuity type income without giving up their capital. Well at least until age 75. Once again, truly innovative product development is being stymied by the age 75 rules.

Nothing happens fast in pensions, so don’t expect a quick revolution but rather a steady increase in awareness and sales. Judging by the number of consultants taking an interest in this market I expect other insurance companies to enter this market. As the current providers are all US insurers, the entry of a UK provider with a strong brand will help boost confidence in the market.