Those reaching retirement with defined contribution (DC) pensions have never had so much choice in how they produce income from their savings. The market is becoming more sophisticated and the choices available ‘at retirement’ are now much wider.

It is a time of difficult decisions for those at or close to retirement with the increasing number of options available for converting a retirement fund into income. For more and more people, this is likely to become an issue. By 2013, around a million people each year will be reaching the ‘at retirement’ market in the UK alone. Indeed, in the UK this accounted for £13.6bn (€17.1bn) in 2007 and is expected to rise to over £30bn within five years.

One of the new options available is variable annuities, which are already very popular in the US. Currently available only from a few providers in the UK, they can provide guarantees on the level of income paid from the product while retaining equity exposure. In the UK, these products are gaining popularity as ‘third way’ products being a compromise between traditional fixed annuities and more risky income drawdown. While this position does not apply in exactly the same way in Europe, where there is not compulsory annuitisation, these products still have great appeal as a way to hedge against stockmarket risks and longevity.

With all these choices (traditional annuities, unit-linked annuities, enhanced annuities, temporary annuities, income drawdown and variable annuities) the decision-making is becoming much harder for those reaching retirement.

In total, there are £300bn of UK pension assets belonging to people older than 45 in individual and group schemes (excluding defined benefits) who could retire in the next 10 years. The bulk of the £300bn is sitting in individual pension schemes as well as DC company pensions schemes such as group personal pensions, and the expectation is that it is this that will drive ‘at retirement’ growth.

The expanding UK market is in part driven by demographics – with the post-war baby boom generation reaching retirement – and partly as a consequence of the personal pension sales boom that began in the late 1980s. This can be illustrated by considering the relative levels of investments in pensions then compared to today, with investments in personal pensions (measured as annual premiums + single premiums/10) being in real terms, £2.4bn in 1993 compared to £0.7bn in 2007.

A lot of those people who took out personal pensions back then are now coming up to retirement age, and with the prospect of a long retirement ahead of them, many will be looking for ways to maximise retirement income while minimising capital erosion. As well as growing in size the ‘at retirement’ market is also growing in complexity. Providers wishing to take a profitable share of this fast expanding market will need not just to design the best products but will need to develop the tools and processes that help advisers and their clients make the right choices.

Traditionally, the choices have been limited for the most part to conventional annuities, unit-linked annuities and income drawdown products. However, now the market is becoming more progressive, there are more and more choices available ‘at retirement’. In 2007, ‘at retirement’ sales were divided between £10.3bn of conventional annuities, £700m of with profits and unit-linked annuities, and £2.6bn of income drawdown. Some £1.1bn of the conventional annuity market was enhanced or impaired life annuities. For the first time, this market exceeded £1bn. Because of medical conditions or lifestyle factors such as smoking, obesity or occupation, it is believed that 40 per cent of pensioners could be entitled to enhanced annuity rates.

Despite these changes and innovations, there is still a large disparity between the fixed interest and fully guaranteed conventional annuity and the option of income drawdown or unit-linked annuities, which offer potential upside in income linked to the stock market but carry the associate risk that markets can fall. The two markets have been quite polarised with income drawdown, for example, only being considered suitable for those with large pension funds, which leaves a form of fixed annuity as the default option for the majority of people with smaller funds.

The introduction of ‘third way’ products might change this situation. Even though variable annuities come in many variations, in the UK they are typically designed as an income drawdown product with the assurance of lifetime income. With much reduced risk, variable annuities open up the income drawdown market to a much wider population. For people in the UK who instinctively dislike the concept of annuitisation this gives a reasonable alternative. In the rest of Europe, the issues are not exactly the same but the principle of retaining potential equity upside combined with a minimum income guarantee is still perceived as a good longevity hedge.

Annuity rates are currently at a five-year high, but traditional annuity rates are expected to be under more pressure in the future because of long-term expected increases in longevity, possible decreases in long-term interest rates, and pressures arising from the supply of long-term fixed term interest rates and the knock-on effect of the ‘cherry picking’ of those with lower life expectancies by enhanced annuity providers. This could make the new alternatives timely. Certainly with the predicted increased level of ‘at retirement’ business, more choice will be welcome.

The key issue in the development of the ‘at retirement’ market is providing scheme members and their advisers or employers with the knowledge and tools they need. With such a wide range of diverse products to compare and evaluate this is not going to be easy. On the other hand, over the next few years retirement advice models will be developed that will compare the different choices, and maybe even take into account other non-pension assets such as housing wealth that could be converted into retirement income by means of equity release.

The research on the ‘at retirement’ market that Watson Wyatt undertook with nine providers this year has already generated substantial interest from non-participating providers (the detailed results were only available to participants) and consequently we have plans to carry out a further, extended projection some time next year. This shows that many providers recognise the development and are beginning to focus on the market.

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