Flexible annuities, the name given to this innovative third generation of products, are designed to offer an annuity based platform for multi-manager investment and inheritance planning.
With only three products launched to date and each very different from the other, this is hardly a homogenous market. Like-for-like comparisons are difficult and probably inappropriate. Here we examine the broader principles that advisers should bear in mind when making recommendations.
Any pension product that bears the label 'innovative' is likely to be complicated and expensive and therefore it is important that the client understands the recommended model and feels it offers value for money. Access to a range of external managers clearly is an important feature but this can be achieved via the Merchant Investors unit linked annuity or through a drawdown plan. Admittedly at present the client must convert to an annuity from drawdown by age 75 at the latest, but if this restriction is lifted then the concept of flexible annuities may be undermined before it has really taken off.
There is no doubt that the wealthy client should have access to a multi-manager choice. For a client who retires at age 60 the investment period of the retirement vehicle is an estimated 24 years for a male and 27 for a female, based on current mortality figures. It is highly unlikely that any one company is going to provide first class investment management throughout this period.
The investment choice for the Prudential Flexible Lifetime Annuity includes access to the company's with profits fund and fund links to M&G, which is owned by Prudential. It also offers a choice of external managers including: Invesco, Merrill Lynch, Newton, Schroder and UBS. Clients can make switches between the funds as their investment objectives change. Every three years the investment choice and income level is reviewed.
Canada Life's Annuity Growth Account offers access to internal funds and to external managers including Insinger de Beaufort's manager of managers range of funds.
Manager of managers is widely regarded as the most sophisticated multi-manager structure and is particularly well suited to clients who seek predictability in performance and reduced volatility. The investment features of London & Colonial's Open Annuity are similar to drawdown although the choice is limited to funds.
Clearly investment choice is not the only important feature. Like drawdown, these products confer considerable control over the level of income and over the death benefits. The upper limit for the income is about the same as the client would get from a conventional annuity, but it is possible to conserve the fund and take as little as 50% of this figure.
The death benefits are among the most important aspects to consider. Under a conventional annuity it is possible to buy a 10-year guarantee.
With an investment-linked annuity this is not usually possible because the income cannot be assessed precisely as this will depend on returns achieved. However, a flexible annuity product like the Prudential Flexible Lifetime Annuity adopts a different approach by allowing clients to identify the proportion of the fund they want to pass on, in the form of income, to dependants. Like the conventional annuity guarantee, this 'ringfenced' fund can run for up to 10 years. During this time it can account for up to 80% of the total fund. The ringfenced fund, which can be transferred to the main annuitised fund at any time, does not benefit from the mortality cross-subsidy but it is still invested and provides part of the income. After 10 years any ringfenced fund is automatically converted to the main annuitised fund.
Clients who opt for Canada Life's Annuity Growth Account effectively buy a five-year temporary annuity and leave the rest of the fund invested. After five years the client can repeat the process or convert to a lifetime annuity. The client can continue this process until the last review before age 85, at which point the remaining fund must be annuitised. This product is generally suited to clients whose partners are in poor health.
The death benefits can allow for 50% of the fund to go to the spouse, who can purchase a five-year annuity and keep an element of the fund invested or convert to a lifetime annuity.
London & Colonial's new Open Annuity is even more flexible when it comes to death benefits but there is no mortality cross subsidy and therefore this arrangement is more akin to income drawdown. However, the chief advantage of this product over drawdown is that the client does not have to convert the fund to a more conventional annuity by age 75. For the right client it would offer a similar facility to a fund-only drawdown arrangement with the added benefit of permitting the annuitant the option to pass on the remaining fund to dependents on death. The taxation of the fund would depend on the individual's circumstances.
Advisers frequently admire the Open Annuity and are certainly impressed by the way London & Colonial used it to drive a coach and horses through the Inland Revenue's tax rules. But it is not without its critics. Nick Flynn, annuities manager at Wentworth Rose, says: 'London & Colonial has certainly created a precedent in the marketplace for return of capital within an annuity. However, the Gibraltar base, the minimum premium of £250,000, and the significant charges, are likely to put many clients off.'
Flynn is concerned about the long-term security of the Gibraltar base and unconvinced about the backing companies.
He says: 'It does not help that companies involved in the set up of this contract are mostly unknown in the UK. This does not automatically make them financially weak but Wentworth Rose's investigations have not been over-encouraging. There does not appear to be a strong parent company of the size that would allow us to add this product to our panel.'
Nevertheless, this remains an option for wealthy investors who are keen to use their pension fund for inheritance planning rather than to generate a lifetime income. The return of fund on death is achieved through the separate Gibraltar structure that, in exchange for the purchase a £1,000 preference share in the insurer at the outset, is able to hand over to the estate of the policyholder the equivalent of the outstanding fund.
key points
There are three flexible annuities on the market and it is important to examine the pros and cons of each before making a definite choice.
The products are complex and are appropriate mainly for high net worth clients.
The products all carry investment risk and different levels of mortality risk.