News Analysis: The pounds 10bn annuity timebomb

How can life insurers provide the retirement income they guaranteed?
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WHEN AMP, the Australian insurance giant, decided to bid pounds 510m in new money for NPI, the mutual insurer, it knew it would have to accept NPI's financial condition, warts and all.

As with other insurers, NPI now faces the problem of meeting its share of the multi-billion pound exposure caused by providing annuity guarantees.

Analysts say NPI needs to set aside about pounds 300m to cover this. Other insurers such as Equitable Life may have an exposure of up to pounds 1bn. The total sums involved are gigantic: up to pounds 10bn for the whole life insurance industry.

What exactly is the annuity guarantee problem? The issue has crept up on the industry in the late 1990s, but its roots lie in the 1960s and 1970s. Starting in 1956, life insurers began to guarantee pension customers a minimum rate of income from savings when they eventually retired and bought an annuity.

At the time it was just a sales gimmick. The idea was that customers buying the old form of personal pensions - known as retirement annuity contracts - faced a fundamental uncertainty when they retired.

On retirement, customers would be forced by the rules to buy an annuity that paid an income until death. The income paid out by the annuity depended on the assets used to back it, namely 15-year gilts. But gilt yields would fluctuate with long-term interest rates: pounds 100,000 in pension savings might buy an income of pounds 16,000 this year, but pounds 13,000 next. Savers could never be sure how much income to expect.

The sales gimmick usually involved a clause promising customers a minimum annuity rate. Typically the clauses guaranteed an income worth at least 11 per cent a year of the amount saved, so pounds 100,000 would yield an annuity income of at least pounds 11,000.

Life offices believed the guarantees would cost them little. Since the Second World War long-term interest rates had been high, a reflection of the inflationary climate. It seemed highly unlikely that annuity rates, based on long-term interest rates, would fall below the guaranteed level.

Now comes the euro. In the past two years, as markets anticipate lower rates of interest, gilt yields have plunged to unprecedented lows. Life offices, caught in a trap they set themselves, face an unpleasant gap between the amount they receive in pension savings and the cost of financing the annuity they had promised.

Worse, the actuaries of the 1960s failed to take into account longer life expectancy. As people now live longer, annuity money is stretched over a longer period. The life office can't afford to pay as much in annual income, but the guarantees may force them to.

The total cost to the industry is estimated by the Government Actuary to be more than pounds 7bn. HSBC Securities estimates that further market changes could push this to pounds 10bn.

Unlike pension mis-selling, the guarantees are spectacularly good news for customers, especially those about to retire. Without them customers would have to plump for an annuity based on current market conditions. With long-term interest rates so low, these give smaller retirement incomes than they have done for 30 years.

Stuart Bayliss of specialist adviser Annuity Direct says that by insisting on the guarantees, customers can bump up their retirement income by an average of 25 per cent. Policyholders may be unaware that they can get this benefit: the industry does little to publicise it.

There is now increasing tension between the industry and the Government over the issue. Equitable Life, thought by some to have a potential liability of more than pounds 1bn, is embroiled in a legal battle with policyholders who claim it should pay up on guarantees.

Equitable claims that it only has to honour the guarantees in respect of part of a customer's pension saving. The terminal bonus - a sum paid on maturity and often worth tens of thousands of pounds - need not necessarily be paid to people who want the guarantee.

Policyholders claim this was never made clear and are now taking legal action against the society. Equitable claims the wording of its guarantees fully justifies its stance, but many believe the Treasury is becoming irritated by this attitude.

Last week Patricia Hewitt, Economic Secretary to the Treasury, wrote a letter to the industry warning that the annuity guarantee problem must not be allowed to affect the benefits policyholders can reasonably expect from policies. In other words, life offices should not lower their bonuses to pay for the problem: any extra money needed should come from free assets.

The letter was interpreted as a veiled swipe at Equitable, which has comparatively few free assets. If it were forced to pay the guarantees from free assets, the impact on its financial health could be serious. It could even have to demutualise.

Ms Hewitt said the cost of the problem would largely be borne by the long-term funds of life offices. In quoted companies, these are 90 per cent- owned by policyholders, while shareholders have a 10 per cent stake. So most of the cost is borne by policyholders.

But if the pounds 7bn required to pay the guarantees grows, bonuses may be affected. In that case, says Ms Hewitt, shareholders will have to plough more money into the funds.

For the moment, most life offices have enough free assets to set aside the cost of the guarantees without slashing policy benefits. But it could get worse. John Russell, a senior analyst at HSBC Equities, feels that is more than a distant possibility. The cost of the guarantees depends on long-term interest rates: the lower they are, the more the guarantees cost.

If economists forecasting a period of deflation are correct, long-term interest rates could fall even further, massively increasing life offices' exposure.

To escape further trouble, life offices need higher interest rates, and that needs higher inflation. Mr Russell says: "Having worried about inflation for the last 30 years, the hole the industry has dug for itself is to be in a position where deflation is more of a threat. Inflation could, paradoxically, let the industry off the hook."