Unit-linked guarantees: securing your clients’ retirement
Passing on the risk
When it comes to retirement planning, individuals are being asked to take on more and more of the risk themselves, including investment, inflation, mortality, morbidity, longevity and interest rate risk. And, with reducing state and employer defined
benefit arrangements, that trend looks set
to keep on growing.
Unit-linked guarantees offer the chance to pass on some of this risk to life companies in a transparent, flexible, economic and financially sound manner. Other products, typically annuities, can also pass on this risk and they play an important part in retirement planning. However, annuities tend to be much less flexible and annuity rates have been on a downward trend for a generation. Downward pressure is expected to continue in the near future due to increasing life expectancy and imminent regulatory changes.
Protection with upside potential
A unit-linked guarantee is not a product itself. Its basic construct is a unit-linked product – such as pension drawdown or onshore and offshore bonds, which advisers are comfortable with – with a guarantee addition that offers policyholder protection. This protection could apply to income, capital, legacy benefits or a combination of these.
Unit-linked guarantees give individuals access to the equity and bond markets, where they can benefit from the market upside while enjoying protection from the downside. Most products have the facility to ‘lock in’ the market upside, so investment gains aren’t lost when markets fall. This is why guarantees thrive in volatile markets. If markets moved
in straight lines – which they don’t –
guarantees would have much less worth.
Cruel maths: the sequence of returns
Volatile markets highlight the ‘mathematical’ difficulties of recovering from market falls and the risks of taking income in falling markets. For example, if an investment were to drop 33% in value, it would have to increase by 50% to recover to the higher level. This principle applies to taking income in a falling market – a significant risk that can easily be overlooked.
In a falling market, capital erosion is greatly increased as a fixed income becomes an ever-increasing proportion of the investment. The return needed to reach higher capital levels can spiral out of control, and capital can be quickly exhausted. This is pound-cost averaging in reverse, and is where long-term income and legacy guarantees can provide real protection and value.
The graphs provide an extreme example of how much the sequence of returns affects overall benefits for an individual taking income. The returns are a mirror image of each other and both overall 6% a year, over a 20 year period. If no income was taken the end result would be the same. But the outcomes here are very different.
Assumptions: £50,000 investment, growth as above, nil charges, £2,500 withdrawn each year in advance
These are for illustrative purposes only and are intended to demonstrate how the product features work. They in no way reflect how we think the product will perform.
For the investor in a falling then rising market, taking 5% withdrawals has completely eroded their capital after 17 years. However, when the market follows a mirror opposite pattern, the investor who has taken 5% withdrawals throughout has capital in excess of the original investment after 20 years.
Guarantees can remove the risk of taking withdrawals in falling or volatile markets.
Cost
To secure the guarantee, the individual has to pay an explicit charge. This is very much in line with Treating Customers Fairly and authenticates the guarantee as an optional feature. All other charges are identical to the unit-linked product.
For the insurer, the cost of providing the guarantees is driven primarily by market conditions. Equity volatility levels and long-term interest rates are the key variables when pricing. So, if there’s a significant movement in these markets, the guarantee charge for future new business will change – pricing for new business is dynamic to market conditions.
Relative to other policyholder costs, the guarantee charge is sometimes criticised for being expensive. However, this is an unfair comparison as other costs aren’t mitigating market risk, and the guarantee cost can only be calculated using detailed capital market knowledge and significant computing power.
For example, guarantee costs have previously been branded ‘too high’ during market conditions that required providers to then increase guarantee costs for new business. This highlights the disconnect between the cost of guarantees and the perceived cost of insuring market risk: an emotional barrier that has to be overcome in some sections of the market. A guarantee charge above 1% doesn’t automatically mean the protection it provides is poor value. The key is whether it provides the protection the client requires to meet their retirement needs in the market conditions they’re facing.
Part of the retirement solution
However, that’s not to say that guarantees are necessarily always the answer. They’re clearly not the only retirement solution, and like any form of insurance are sometimes not triggered in practice. If the guarantee isn’t triggered, the guarantee charge will have been a drag on investment performance – just as paying for full comprehensive car insurance is a cost with no benefit if no claims are made, and third-party cover could have been taken instead. But we’re not blessed with the benefit of hindsight. Insurance is still valuable protection even if it’s ultimately not needed. If it needs to pay out, you’ll be glad you’ve got it; if it doesn’t need to pay out, it’s also good news in that your investments have performed well.
It’s worth considering guarantees when discussing retirement provision with your clients. They could form a part of the solution for individuals who want to benefit from growth in the market but have protection from market risk as well.
Ability to pay the guarantees
As the guarantee liabilities rest with the provider, and there are no caveats (except insolvency) for their non-payment, a robust risk management programme is essential to make sure they’re honoured.
The key to any risk management program for guarantees is using simple financial instruments to hedge market risk. Very simplistically, this means income from the guarantee charge is invested in simple liquid derivatives that provide a cash flow that helps offsets the increase in value of the guarantee. So, if markets fall and the value of the guarantee increases, the providers have an asset that increases in value to help offset the increase in the value of the guarantee. Each provider will have sophisticated models and rigorous checks in place to make sure the hedging strategy is working as expected.
Financial Regulators require providers to hold enough capital to support guarantees under extreme market conditions. As a result, providers reserve high levels of capital against these liabilities.
Unit-linked guarantees in the UK have been honoured throughout the recent financial crisis, and have provided real consumer value.
This communication is for professional financial advisers only. It isn’t for private customers and shouldn’t be given out to, or relied on by, them.