The second-hand annuity market will stumble if IFAs cannot be persuaded to offer consumers the advice they need, writes Adrian Boulding
On 6 April 2017, the secondary annuity market will be declared open for business.
The ground is being laid with the publication of regulatory and government policies and consultation papers.
- These include the Financial Conduct Authority's (FCA) consultation paper 16/12 Secondary Annuity Market - proposed rules and guidance
- HM Revenue & Custom's Creating a secondary annuity market: tax framework
- And the Department for Work and Pensions and HM Treasury (HMT) Creating a Secondary Annuity Market - Response to call for evidence consultation, published last December.
We now know that the existing annuity market is made up of 6 million policies, being paid to 5 million people. The market is worth £13.3bn per year.
HMT predicts that only 300,000 will be tempted to cash their annuity pots in.
The FCA is slightly less sure - putting the estimate of market size in the first three years somewhere between 102,500 and 305,000.
All agree that the market will tail off rapidly in the third year of offering this facility to annuitants (i.e. from 2019/20 onwards).
Modest incomes
The perceived wisdom is that most of those cashing in will have relatively small pots which are delivering less than £50 per month to the annuitant.
For some of these people, this offers them an opportunity do something meaningful with a lump sum - buying a new car or clearing down some outstanding personal debt, for example.
It is also possible that others will aim to reinvest the lump sum in a more flexible retirement savings product like a new flexible annuity or flexi-access drawdown policy.
Some will want to cash it in to improve the terms of their annuity in the interests of dependants and spouses.
Many might want to turn legacy single life to new joint life policies, perhaps now feeling guilty about a selfish choice made at retirement.
Buyers market?
We also have some idea from the FCA's paper that in the region of ten players will be in the market to purchase annuities from next April. The prediction is this number will fall to seven as the market opportunity shrinks in year three.
The expectation is that your incumbent annuity scheme provider is not likely to be buying back your annuity - 30 annuity providers have already declared they will not be doing that.
So who will be buying, given the clear risks of so doing? The answer is many of the ten layers will be institutional investors with the underwriting and actuarial wherewithal to value and buy these annuities - most probably the re-insurance giants who already underwrite vast swathes of the annuity market.
Does that matter? It is a shame in a way as the original annuity provider would probably be able to offer a better price than the secondary market.
The mortality risk is a perfect match for them and they get to save the cost of actually sending out all those future payments. Whereas other buyers who want to go short on longevity to counter existing long positions will have a mismatch, as the lives they buy won't be the same as the lives they have sold or re-insured annuities for elsewhere.
What is not clear yet is the extent of medical evidence that will be required.
In total, sellers could be looking at a 40% loss of value for the convenience of getting their hands on that money quickly
Obviously, for a large annuity, they will need to get detailed medical records updates and complete some pretty substantial due diligence.
For a smaller annuity, they might settle for a GP's report, particularly if they are one of the more technologically advanced institutions that now has electronic access straight into patient's medical records (with permission of course!).
For the smallest of annuities, a simple customer declaration may even suffice.
Interestingly the consultations propose that the customer must also be shown the cost of buying his annuity today on the open market as if he were once again starting out on retirement and converting his pension pot into an annuity.
This will starkly reveal the "spread" on the transaction, which I am expecting to settle at around 20%.
Annuitants will also be taxed at their marginal rate for receiving the lump sum which for many will mean another 20% over and above the tax they would pay if they carried on taking the small monthly payments.
So in total, they could be looking at a 40% loss of value for the convenience of getting their hands on that money quickly. How many will want, or should be advised, to take that hit?
This is where bond markets come to the rescue. Eight years ago long-dated gilts were offering over 5% per annum, today it's less than 2%.
That collapse in gilt yields - and a similar pattern for corporate bonds - means that the assets underlying the annuity have appreciated considerably.
In selling an annuity you are effectively selling those assets, and selling them at the top of the market which is always the best place to sell!
If buyers look back over their past and calculate what they originally paid for the annuity less the total of pension instalments received to date they may be quite impressed by the surrender value today. Provided that is they need a lump sum and are not trying to buy another income stream.
Lack of adviser interest
Perhaps more worrying is the clear lack of appetite from the advisory community to offer advice around these transactions.
Again, like the ‘insistent client' problem, IFAs don't want to be on the hook for compensation forever more, should the customer find the lump sum does not stretch far enough into a lengthening retirement.
Meanwhile, HMT estimates is set to see a boost to tax receipts in year one (2017/18) of £485m and £475m in year two of annuities trading.
Thereafter it is expected that those that want to do this will have completed transactions and HMT will actually incur losses due to offering annuitants pension freedom.
This really does look like a short-term market.
Once the pent-up demand is satisfied, we will see more recent annuities coming to the market, and they won't have benefited from that bond bubble effect.
Indeed, should interest rates ever normalise, we would have a period of particularly unattractive second-hand values. If you are one of the people that bought an expensive annuity in recent years while interest rates have been low, then your position is bleak, as having the chance to sell on something today can never address the issue of having paid too much for it in the first place.
The other question is whether wrap platforms are likely to offer the tools and administration capability to provide the marketplace for these transactions.
One annuity market expert who I spoke to is talking to many platforms, says that the likelihood is that the wrap platforms will follow the lead of advisers and choose not to play. This will leave the marketplace creation work to the D2C players like Hargreaves Lansdown, Charles Stanley and Nutmeg.
So despite the clear need for regulated financial advice, those looking to cash in their annuities may be doing so through robo-advice which must present the regulator (and incumbent providers alike) with some concerns.
Disclosure documentation will demand not only all quotes from buyers are presented net of the firm's estimated forthcoming charges in descending order of value; but also a quote of the replacement cost of the annuity income (were it to be bought on the open market) at the same time.
The platform will also need to disclose the number of buyers on the panel and any relationships that platforms have with would-be buyers.
There is some suggestion in the original HMT/DWP document that annuity contracts may be securitised and bundled into investment funds creating a tertiary market.
This really does look like a short-term market
This all sounds like worrying stuff where the end buyer is not likely to have a clue about the real value of a bundle of annuity contracts. Shades of the CDOs which hastened the banking crisis just ten years ago here.
Furthermore, how will the new parties to an annuity contract know that the original annuitant has passed away, thereby ending the contract?
One of the main sources of information to annuity providers today is the customer's bank, who will bounce payments back once the annuitant has died.
But in a second-hand market, this link between recipient and ongoing existence is broken.
We do issue death certificates in the UK, but they are still done on a local rather than national basis. The best source of information is the state pension, as governments make sure it stops paying the state pension whenever a death is certified.
But to date, the government has shown no willingness to share that information source with the second-hand annuity market.
Summing up
In conclusion, to make a market work well for all parties there needs to be a good quantity of buyers and sellers as well as platform-based market makers and advisers to ensure the consumer is doing the right thing - especially as the risk of consumer detriment here is undeniably high.
It seems likely there will be no shortage of sellers - in the first two years at least.
However, the buyers will, in the main, be a small number of highly sophisticated reinsurance giants looking to cover the medical costs around quotation and to make a fair turn as they buy in annuities to offset their existing reassurance exposures.
But a real problem may be the short-lived nature of this market. Is it worth an adviser going through all the training to handle a market that might only last a couple of years?
And is this long enough to justify the investment in IT automation to handle the administration around these transactions?
Will anyone risk launching a robo-advice service in a section of the market that will be under close scrutiny from consumer associations and politicians alike?
I really hope we can get over these issues, as selling up will be a good option for those with another source of income but a shortage of capital.
And being granted that opportunity to sell redresses the balance for those who retired before the arrival of pension freedom and who felt that they were forced into buying an annuity they never wanted in the first place.
Adrian Boulding is retirement strategy director at Dunstan Thomas
