Annuities that invest in the stock market or with-profits funds, commonly known as investment-linked annuities, have been available for some time. Commercial Union and Provident Mutual were among the first to offer a form of unit-linked annuity, but it was not until Equitable Life launched its with-profits annuity (WPA) in 1987 that these products became widely accepted. The next milestone was when Prudential entered the WPA market in 1991. This was quickly followed by Scottish Widows and Norwich Union, and by 2000 the WPA providers included Standard Life, Scottish Mutual and Sun Life.
The dramatic fall in equity prices in 2001, and the subsequent bad publicity surrounding with-profit funds in general, halted the demand for WPAs. Subsequently a number of insurance companies, including Standard Life, pulled out of this market. Today there are only four companies providing WPAs: Legal & General, LV, Prudential and Norwich Union. Prudential is by far the most dominant provider.
In 2008, more than £11.5bn of pension annuities were purchased, of which £11bn were fixed and retail prices index annuities, and £500m were investment-linked annuities – of which the majority are with-profit annuities. In addition, £3.2bn was invested in pension drawdown. The figures for WPA sales show that WPAs are a small, but important percentage of overall annuity sales.
What is a with-profits annuity?
WPAs are invested in a with-profits fund, which means annuitants share in the future investment gains or losses of the fund. This is in contrast to standard non-profit annuities, where the income is guaranteed but there is no investment growth.
WPAs have the normal annuity options available, eg single or joint life and choice of guaranteed periods and payment frequencies, but the big difference compared to standard (non-profit) annuities is that every year the annuity income is recalculated to take account of the actual bonuses paid to the companies. Income in future years can be higher or lower than previous years.
Income choice annuity
Prudential is set to inject new energy into the WPA with the launch of a new type of WPA policy called the ‘income choice annuity’. It allows investors to choose the starting level of income between a maximum and minimum amount. This can be reviewed annually and potentially changed every two years.
It also has a guaranteed secure level of income, a minimum below which the annuity cannot fall, no matter what happens in the financial markets.
The starting annuity payments are not guaranteed, but future income payments will rise or fall in subsequent years depending on future bonuses paid by Prudential.
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How does income choice work?
There are two important concepts to understand:
- required smoothed return (RSR);
- declared smoothed return (DSR).
The DSR is the actual bonus added to the annuity at the end of each year. If the DSR bonus is higher than the RSR, the annuity income will increase, whereas if it is lower the annuity income will fall. Table one explains in more detail, showing the starting income for a range of annuity options.
In this example, the annuity with an RSR of 4.5% pays a similar starting income to a level annuity. At the end of year one, the annuity income is recalculated using the actual smoothed return or DSR. This may be higher or lower than the RSR, as shown in table two.
The pros and cons of WPAs
The rationale for any investment-linked annuity is that annuities are a long-term investment and so should be invested in long-term assets such as global equities and property, which aim to provide an effective hedge against inflation and potential for income growth.
Most people need an income that has the potential to grow to meet their ever-increasing expenditure and life expectancy, but find the cost of inflation-linked annuities too expensive. Providing investors understand and accept the additional risks, investment-linked annuities allow investors to choose the level of starting income and benefit from future growth if returns are higher than anticipated.
What are the advantages?
- It combines the advantages of an income for life with the potential advantages of investing in the stock market;
- With-profit funds smooth investment returns, ironing out investment peaks and troughs;
- In certain circumstances they are a good alternative to pension drawdown;
- They provide the potential of a growing income, with the security and peace of mind associated with standard annuities.
