Medical underwriting of annuities is not new; it has been growing in the individual annuity market, but it has only recently been applied to DB scheme bulk annuity exercises and to good effect.
It is interesting that around half of people retiring have a medical history that can lead to more favourable annuity terms – a sort of good news bad news story. The good news is you will get a bigger pension; the bad news is you may not enjoy it for long. There are four things that impact the size of annuity: how much you pay in, how long you work, investment choices and shopping around. Medical history is the new fifth factor.
I remember when the use of postcodes was a great innovation in the bulk buyout market and how providing postcodes was seen as racy and against the Data Protection Act by many trustees. Until that is, it was recognised that the use of postcodes allowed more accurate (and usually keener) deal pricing. Postcodes are now used as standard, but it took a few years to gain traction. What made the difference was the knowledge that it was information useful in the management of the pension scheme. It gave providers who used it a short term advantage until others caught up.
Medical underwriting of bulk buyouts is really an extension of the postcode principles – using individual information to get a more accurate view of the mortality of the scheme membership.
It is going through the same development pattern as postcodes and I believe it will become a standard component of bulk annuity pricing in the years ahead as provider experience develops and customer familiarity grows.
While we are in a developing market, there are some issues to deal with, including customer knowledge and understanding, variable practices and standards among providers. And then there was the 2014 Budget.
Recognising the first two issues, in February 2013 a report by the Pensions Institute, sponsored by Partnership and JLT, entitled “A Healthier Way to De-Risk”, signposted the need for a Code of Conduct and guidance to ensure consistent, safe and efficient practice in this new area of medical underwriting in relation to DB scheme de-risking. It also expressed a need to inform stakeholders.
The different providers of these new de-risking solutions adopt different approaches, and should the market grow quickly, there is a risk that different requirements, factors, forms and timescales in approach will confuse the market and make the solution unattractive for the wrong reasons. I am a great believer in standardisation of the data and process wherever possible, leaving room for differentiation in the calculations, so I believe we should encourage simplification. However, the contrary view is that the industry is so new it needs the freedom to develop products and approaches to maintain competitiveness. Shared procedures and collateral will emerge in future.
In the meantime, customers need information to help them understand the solution in general terms as well as appreciate the variety of approaches and how those approaches may affect outcomes.
The Good Practice Guide
Last year, I was asked if I would lead on the development of a guide to good practice in this new area, so I set about gathering together a group of key stakeholders (including insurers, consultants, advisers, trustees and lawyers) to help. The guide will be published later this year and it will explain medical underwriting, how it works and the benefits of the approach, as well as the potential downside. For example, if you are medically underwritten and don’t like the outcome [you are too healthy], the genie is out of the bottle and you cannot conceal that knowledge in a later application for cover. The same applies to a bulk exercise and some trustees may find this uncomfortable.
Additionally, a bulk annuity exercise using medical underwriting gives results that help the scheme as a whole rather than individual members. Premiums may be 10% lower, making buyout more affordable, but none of the individuals themselves get a higher pension – all receive a standard annuity. This can be challenging to explain, but generally scheme members are fine with this.
The drafting team has been busy for the last few months and the key sections have been written and are being internally reviewed. We have external reviewers, including the Society of Pension Consultants (SPC), which kindly agreed to help us with an independent review. It has been a great exercise in industry-wide co-operation.
The Budget – the last of the issues
The March 2014 Budget proposed that from April 2015 people aged 55 will be able to take their entire fund as cash or invest it as they wish. People have always been able to take more than 25% as cash, if they were prepared to pay the significant tax penalty (55%). The tax cost for excess cash will become the member’s highest marginal rate, which in some cases could be 60%, so the freedom is not quite as new or as free as suggested. Equally, there has not been compulsion to buy an annuity on retirement for some time. However, it is widely anticipated that the change will make some difference, especially over the short term.
The immediate reaction to the Budget was that this would be the end of annuities, and in particular enhanced annuities, with the market predicted to shrink from £12bn to £5bn a year. Firstly, this assumes that people will take cash and blow it on a Lamborghini (or more likely on lamb chops, given the average pot size is £30,000).
Inevitably, there will be an initial rush to cash, but that will calm down, especially when people realise that the Treasury will take a significant chunk off and will resist or spread or defer. 400,000 people retire from DC schemes each year and most will continue to need or want a secure lifetime income – even if guidance tells them how long they have to live.
Annuities are relatively simple, although seen as poor value currently; drawdown and working out how long your cash will last is more complex and stressful. I am more concerned that people will be tempted into liberation scams rather than traditional annuity providers, so education of members will be essential and the Guidance Guarantee set out in the Budget will help.
Do I believe that there is a strong future for medically underwritten bulk annuities? Do I think freedom and choice is a good thing? Yes, I do. I see a future with annuities alive and well, but more flexible than now and, more tailored to individual circumstances. This includes medically enhanced annuities, whether bulk or individual.