Pension freedom or trap for the unwary?

An interesting development is the pending right of annuitants to sell their future annuity payments for a cash lump sum, planned for introduction in 2017. The new option will only apply to holders of individual annuity policies with insurers, either from initial purchase of an annuity or because they are holders of individual annuities following a buy-out. The state pension is excluded, as are pensions from a defined-benefit occupational scheme (being covered by a grouped buy-in policy or longevity swap won't change this since these are assets of the pension scheme, not the individual).  There may also be some interesting twists and turns for schemes which have set up their own captive insurer.

This new option isn't the same thing as "surrendering the annuity", as with many other insurance policies, since the annuity will remain in force and annuity payments will continue to be paid to the buyer. The buyer may be a third party, with the insurer paying the annuity payments to the buyer as long as the annuitant lives. There are many aspects to this development, but I want to look at just one: whether the insurer paying the annuity should make the annuitant an offer and thus cancel the annuity.  Superficially the insurer should always make a bid that is less than the current best estimate of the value of future cashflows.  If the bid is beaten by another buyer, the insurer has lost nothing apart from the time and cost in making the offer.  If the insurer is successful, it can effectively cancel the risk under the annuity and seemingly make a profit by removing a balance-sheet liability at less than best-estimate cost.  What could go wrong?

As it happens, plenty.  Part of the problem lies in the fact that the mere act of putting the policy up for auction is potentially an informative event in itself.  Specifically, why has the annuitant chosen to do this?  Is it perhaps because the annuitant has information on his or her health which makes future annuity payments of very little value?  Consider the case of an annuitant with a reliable medical diagnosis of less than a year of life remaining.  The value to the annuitant of payments after the second year is therefore zero.  Any offer of a cash value for the payment stream greater than one year's payments is therefore a win for the annuitant.  However, if the insurer does not have this information it will assume a normal life expectancy and thus a corresponding reserve allowing for the expected value of payments in the second and subsequent years.  Any cash offer greater than one year's payments is therefore a loss for the insurer relative to doing nothing.

One proposed solution to this asymmetry of information would be to have the annuitant fill out a health questionnaire.  However, it is difficult to see how to handle the problem of non-disclosure.  In the case of non-disclosure for an assurance policy the procedure is well established: the claim is denied, the sum assured is not paid out and the premiums are returned to the policyholder.  Claim events in life insurance are relatively rare, so fraud is easier to spot and the overall cost burden of investigation is modest relative to the large savings in unpaid fraudulent claims.

In contrast it is harder to see how non-disclosure could be managed for a newly purchased annuity cashflow: it is hard to know if an early death was the result of an undisclosed condition, to say nothing of costly and time-consuming to prove it.  After all, every annuity will cease through death and annuitants are elderly, so there could be many potential investigations required.  There is also an element of shutting the stable door after the horse has bolted: the cash lump sum has already been handed over, and may have been spent.  If not, the insurer faces the long, drawn-out process of trying to reclaim the lump sum during probate.  And if there were a elderly surviving spouse inheriting the annuitant's estate, reclaiming the lump sum could be a public-relations disaster.

The idea of selling the right to annuity payments no doubt sounds appealing to some annuitants.  After all, it is an additional option which they didn't have before and which doesn't need to be exercised; the annuitant has nothing to lose.  However, buyers of such cashflow rights will have to think very carefully indeed about the risks they are running.