One of the more significant developments in the annuity market over the last couple of years has been the growing awareness among Trustees of their responsibilities in relation to the incomes of members vesting from Defined Contribution (money purchase) schemes. The vesting of Additional Voluntary Contribution (AVC) funds now more frequently requires the purchase of an annuity and the need to source appropriate rates.

Although this direct responsibility for ensuring best outcome was confirmed in the Pensions Act 1995, many Trustees had simply relied upon their advisers and administrators to recommend and transact the purchase of the annuity. In turn advisers and administrators had been happy that they were carrying out their duties satisfactorily without the necessity to go through the full rigour of the Open Market Option (OMO) or advice to the member. Quite often arrangements were in place whereby all members were recommended to take their annuity with a particular "good" annuity provider.

These "good" annuity providers were normally major companies whose rates were frequently in the top five but closer examination would indicate that they were relatively infrequently top, particularly for the smaller funds. Also the standard advice did not take into account the particular circumstances of a member, most notably if they or their spouse (in the case of joint life) were sick and eligible for an enhanced annuity.

Pension fund advisers and administrators have over the last two years started to discuss whether these services are good enough in the light of the Act or whether a full OMO service is what is required by the legislation. These discussions have led to three conclusions:

• Trustees and advisers do need to ensure that the members obtain the best rates and impaired life rates where appropriate. Therefore, a full OMO service is required.
• How much the OMO service costs, who pays and how, are difficult issues that need to be resolved. Fees versus commission, particularly with so many small funds, is not a straightforward debate and the resulting solutions have sometimes surprised the participants.
• Given that Trustees and advisers are aware of many cases where optimum solutions have not been obtained for members, is either party vulnerable to regulatory or legal redress?

The OMO service needs to allow for the member’s particular circumstances and choices within reason. This requires Trustees to facilitate discussion and information with the members in order that they are able to make informed choices and have sufficient time to complete medicals where appropriate.

It should be expected that over the next couple of years vestings from defined contribution schemes will move to an OMO basis. This in turn will have a number of effects on the annuity market:

• The value of funds exercising the OMO would be increased by 50% as a result of this alone. The number of OMO transactions being processed by insurers will increase by two and a half times. These predictions may very well be exceeded as they are based on 75,000 vestings at an average of £10,000.
• The cost-effectiveness of these transactions and any resulting impact on annuity rates could be significant.
• This negative impact on rates would be offset by the likely reduction in average life expectancy that the top OMO company will experience. This is because the current IFA-based OMO is for larger average funds and, crudely, people with more money live longer. Defined Contribution schemes not only have smaller funds but were frequently first introduced for lower paid employees.
• The effect of defined contribution vestings on the enhanced and impaired life annuity market is likely to be very substantial. Only a small proportion of those eligible for enhanced and impaired life rates currently obtain them. New developments, such as enhancement resulting from an impaired second life, are not fully understood by the marketplace.

The requirements of the defined contribution market will in themselves have significant effects on the size and cost structure of the annuity market over the next couple of years. However, the behaviour and needs of this market are only one part of what is currently happening in the world of annuities.

Having established that Trustees and their advisers will be having a growing impact on the annuity market, it would be helpful to review what is currently happening and particularly compare the general perception of annuities with the reality. That perception can be summed up in the following headlines: "Pension income – an annuity lottery", "Annuity rates collapse", "Pensions in peril from poor annuities".

Indeed, conventional annuities have for the last two years remained at their lowest level for the last 40 years. As it is 40 years since long term interest rates were at their current level and over this period the expected length of an annuity has increased by 70%, you could argue that annuities, with rates approximately 15% lower than those available in the 1960s, are relatively very good value.

This improvement in pricing has resulted from a much broader range of bonds and fixed interest investments. Insurance companies often have an average of single A grade bonds in their annuity fund; this provides a net return in excess of gilt yield. The remaining relative price improvement is made up of lower costs from admin efficiencies on set-up and payment.

This sounds quite good news but anyone who knows the quality of admin systems at vesting will know that there is substantial room for improvement.

The relative value of annuity rates is not the only measure that indicates retirees are facing the consequences of our economic transition from high interest rates, high inflation, to low inflation and low interest rates. A simple illustration of this is seen in the table below. Deliberately, no account is taken of charges and single life annuities are used. The percentage of final salary achieved will have declined since 2000 as a result of poor investment performance but the message is still valid.

These real world examples throw a lie to the oft quoted statistic "A man of 65 in 1990 got £15,000 for his £100,000; a man of 65 in 2000 got only £9,100 for his £100,000". In the real world it can’t be the same man and the £100,000 is not the same £100,000.

We conclude that the conventional annuity lives in the real economic world and is much more efficient than it was 40 years ago. So what are the problems?

The biggest is that when you buy a conventional annuity you make a once in a lifetime purchase at the current rate which in turn reflects the current market rate for long term gilts. For this to be a good economic decision the average level of interest rates and inflation over a retirement lifetime will need to have been at or below those on the date of purchase. Given that the average length of an annuity is now 20 plus years, there are two problems with this:

• 20 years is a really long term bet – one that most of us would not want to risk.
• If you are purchasing at a time of historically low levels of inflation and interest rates, you will not be happy as there is a high probability that rates and inflation would on average be higher during your retirement lifetime.

The biggest problem with conventional annuities is therefore not their current value but their possible future value and the length of the average retirement lifetime.

The last few years have seen some rapid product development.

• Annuities with flexible investment basis, including unit-linked and with-profits, are available from most of the major pensions companies.
• Income drawdown allows you to take an income from a pension fund while retaining similar underlying investments to those used prior to draw at least until the age of 75.
• With the growth of the enhanced and the impaired life marketplace, the specialist providers have been joined by the likes of the Prudential and Norwich Union and this trend is set to continue.

But, with the exception of impaired life developments, these new and enhanced products are only applicable to retirees with pension funds of £100,000 or more or substantial non-pension assets.

From the point of view of Trustees, there have been three further complications for both Defined Contribution schemes and AVC schemes which are not being used to purchase additional benefits within a Final Salary scheme.

• You have to decide whether you want to allow your scheme members to be able to access drawdown or investment-linked annuities.
• If Trustees allow it, then the retiree will require independent advice, rarely something that the Trustee or pension fund adviser would want to give. The simple process here would therefore involve a member appointing his own financial adviser and signing a Trustee discharge form confirming that the Trustee is no longer responsible for the pension income outcome.
• With AVCs there is an additional complication of timing as the vesting can now take place before or after scheme retirement date.