Developing a DC pensions growth strategy for life insurers

At a glance
 

• Our initial insight explained why we believe now is the time for life insurers to develop a Defined Contribution (DC) pensions growth strategy.  This article builds on our assessment of the macroeconomic and regulatory landscape to dive deeper into the first pillar of this strategy: the need for life insurers to develop products/propositions that meet customers’ evolving needs. 
• Based on research in the UK and other jurisdictions, we highlight options available to firms to enhance their existing product suite. UK annuity sales increased by 46% between 2022 and 2023 – but 82% of the total was level annuities, giving no protection against inflation. A broader range of annuity options (e.g., inflation linked, premium, escalating) could better meet customer needs and create commercial opportunities for the life sector.  Our article also covers different longevity and investment risk pooling mechanisms (e.g., Collective DC schemes) which may offer alternatives to current products.
• The complexity and evolving nature of customers’ needs will likely not be met by a single product. We suggest different methods such as blending and phasing for firms to develop their DC product suite. We identify deferred later life annuities as a credible solution to cover longevity risk, especially if they are bundled with other, more flexible retirement options such as flexi-access pots. As customer will likely need advice to access these complex products, we also suggest a possible solution to make advice more systematically accessible.
• Converting product development into successful commercial propositions depends on anticipating and meeting capital and funding requirements, as well as other regulatory and policy developments in the market. We are at a cross-roads and the industry will be subject to challenges and opportunities from both policy and regulatory changes. These include Solvency UK reforms, delivering good retirement outcomes under the Consumer Duty, and pressure to allocate DC investment to UK productive assets. Firms need to forge a path that allows them to grow whilst managing risks.
• Finally, beyond the macroeconomic and regulatory drivers shaping firms’ DC growth strategy, the future shape of the decumulation market will be heavily influenced by policy. Based on our research we include some policy ideas that firms might find useful to consider when liaising with policymakers and regulators on pension reform, including the need for long-term stability and certainty, the central role of tax policy in the pensions market, and minimum levels of pension contributions.
• In the next and final article of this series we will explore regulatory and commercial developments around DC distribution models, and the need to bring together teams with the right expertise from both product and distribution areas under the highest level of sponsorship to ensure success.

I. Pillar 1: Products
 

The UK life insurance sector is the only life sector in Europe with a positive growth outlook for 2024¹ driven by pension risk transfers of Defined Benefit (DB) schemes. But UK insurers will need to implement more structural changes to grow and remain competitive in the UK retirement market in the medium term as DB schemes run off.

As outlined in our first article, growth opportunities for insurers in the Defined Contributions (DC) market are substantial. But these opportunities will predominantly unlock to insurers which can (i) design products that meet the changing needs of consumers and (ii) distribute them effectively to well-defined target markets and secure good customer outcomes in the process.

This article will focus on Pillar 1 of our proposed DC strategy: product design. In this paper we propose a product development framework including a range of products and ways of combining them to meet customer needs better. We then consider the regulatory and policy environment and describe some actions for firms.

II. Trends and challenges in the UK DC market
 

Retirement trends have changed significantly in the last few decades. UK pensioners live longer, are healthier, but face health conditions for longer. In addition, a large share of the UK population considers they will need to work part-time past state retirement age², and UK pensioners’ income has increased in real terms since 1995. These trends have changed pensioners’ habits and spending patterns across three distinct phases: early (55-67), mid (67-77) and late retirement (77+). Whilst spending levels remain relatively constant throughout, early retirement is usually characterised by more ad-hoc expenditures (e.g., car purchase, holidays) requiring more flexibility in accessing the pot, whilst regular spending in later retirement is higher (e.g., care home fees, health treatments).

There are three central needs expressed by customers when it comes to retirement income decisions. Their relative weight varies with an individual customer’s outlook, risk appetite and retirement phase:

• Risk management: customers seek coverage against risks, in particular longevity risk (risk of outliving one’s savings), investment risk, and inflation risk.
• Returns: customers want their pot to be managed/invested soundly to secure optimal returns and expected standards of living through retirement.
• Flexibility: customers want flexibility to draw funds from their pot for ad-hoc expenses or unexpected events, and a product that can adapt to their changing needs over time.

Striking the right balance between these three needs should inform firms’ approach to retirement product design. However, the range of available products in the UK is limited, increasing the risk of poor retirement outcomes.

Exhibit 2 highlights the prevalence of full withdrawal at decumulation. This is due to the large numbers of very small pots but also the limited product offering available to customers – most of them being on one end of our customer’s needs triangle (Exhibit 3). This reinforces the need for product innovation in the UK retirement landscape alongside effective pot consolidation to better match customers’ needs and for insurers to maintain a significant role in the pensions market with their unique ability to cover longevity risk.

III. Pension products development framework: recipe to a good retirement
 

As DC schemes increase in size and number in the years ahead (due to the success of auto-enrolment measures), product development at decumulation will be critical to improve pension outcomes. There is no miracle recipe for developing retirement products that meet complex customer needs, but our pension products development framework considers the following components (Exhibit 4):

• the design of individual new products;
• the method used to combine different products/features and package them together; and
• the drivers such as capital, regulatory and operational considerations.

Below we explore each component in more detail.

A. Choosing the right ingredients

 Exhibit 5 illustrates the range of current products available at accumulation and decumulation (top half) as well as the additional products that insurers could bring into the mix considering the changing needs of customers and market conditions. Most of these products will not be a solution on a standalone basis but they will be the basic ingredients of most successful recipes.

A key issue identified in the current retirement market is the low take-up of products protecting against longevity risk or investment risk. Below we explore how insurers should consider integrating a range of annuities, whether used as a packaged product component or on a standalone basis, into their product suite. We also explore other types of products that meet similar needs to annuities by pooling risks among customers.

Annex A includes a glossary of annuity options.

B. Blending and phasing: how the method matters

The other key component in the recipe is the method used to combine the products into pension solutions. 

Blending of products and features is central to improving customer outcomes. Blending allows insurers to:

1. Offer personalised solutions: an efficient product blending structure should consider customers’ needs (Exhibit 3) and risk profiles (individual risk appetite, other sources of wealth, etc). This could include products that guarantee a minimum income for later life alongside flexible options for early retirement.
2. Improve overall customer outcomes: product design processes should incorporate safeguards for well identified behavioural biases, such as underestimation of longevity or expense needs to help the consumer make better informed decision while delivering better retirement outcomes.
3. Increase loyalty/customer retention: by offering a product mix that better meets the needs of customers.

Source: Deloitte, Opportunities for Innovation in the Retirement Income Market

This example may be more suitable for risk-averse customers, or individuals with high regular expenses (rent/mortgage) at retirement. Other types of products could match different needs (e.g., smoothed funds which mitigate investment risk and offer some flexibility) and more complex features (e.g., flexi access pot and tontine-like fund).

Phasing (i.e., blending through time) is another way of combining products to achieve better outcomes. A single product will be unlikely to continue to meet customers’ changing needs throughout retirement. Dynamic drawdown pathways need to be updated after five years, but a deeper embedding of the different phases of retirement and their changing needs into product design could help ensure better customer outcomes.

C. Key drivers: regulation and policy
 

In sections A and B we focused on the variety of products, how to combine them and how a strong product development framework can help insurers establish a DC growth strategy that delivers better retirement outcomes for consumers. In this section, we explore how the regulatory and policy environment are key drivers of a product strategy. This document gives a more detailed overview of regulatory initiatives affecting the pensions sector.

Capital and asset origination needs

Annuities are well known for being capital-intensive and subject to significant regulatory scrutiny. The more complex features and guarantees the product has, the higher the capital requirement. Over the next few years, firms will continue to grow their Bulk Purchase Annuity (BPA) / DB portfolios which will require more capital and appropriate assets to match the liabilities. Developing open annuity books with more complex features will require firms to consider their capital and funding needs carefully, as well as asset origination.

Firms should factor the opportunities offered by the Solvency UK reforms, including the risk margin reduction,  and the interest rate changes to their plans to expand the annuity portfolio. The PRA is also likely to issue its final expectations on the use of funded reinsurance in the BPA market later this year which could increase the costs of funding annuity business in the future.

Broadening the range of eligible assets to match long-term annuity liabilities (matching adjustment portfolio eligible) is also at the centre of the Solvency UK reforms. Many industry players are calling for a more agile sandbox approach between PRA and insurers to enable investment in long-term productive assets in the UK economy. Availability of eligible assets that meet the relevant regulatory criteria will be key to insurers’ ability to implement a growth strategy in this market.  This shortage has been acknowledged by the newly-elected Labour party which has set up a British Infrastructure Council to “act as an enabler to increase the supply of infrastructure projects for institutional investors” and has announced infrastructure developments reforms.

Delivering good retirement outcomes under the Consumer Duty (the Duty)

The Duty is a significant challenge as well as an opportunity for the pensions sector. The findings of the Retirement Incomes Advice review earlier in 2024 paint a worrying picture for the pensions advice sector. The FCA concludes, that had the review been conducted today, most firms would not be compliant with the Duty. In parallel, HMT and FCA are exploring changes to the advice guidance boundary to narrow the advice gap and improve retirement outcomes. These topics will be explored in our next article on the distribution pillar of a DC growth strategy. But potential changes to distribution and advice models will need to be fed back into product development as changes in the distribution model become clearer.

Value for money and investment strategies in DC pensions have also been at the centre of political debate in the past year. The Mansion House Compact reflects some of this pressure, with the largest life insurers committing to allocate at least 5% of their default funds to unlisted UK equities. In the words of the IMF: “Reforms to unlock pension savings for higher-return investments should not undermine financial stability or pensioner outcomes”. Firms will need to navigate the tension between seeking higher returns and delivering good retirement outcomes in the medium and long term under the Duty.

The Importance of pensions and tax policy

In our research we identified some commonalities across regimes where the pensions landscape or some of its elements are considered successful. The points below could be of interest for firms when liaising with policymakers and regulators on pension reform issues:

• Policy stability: is considered central to ensure both consumers and industry can make long-term decisions that will not be reversed. Over the past few years, the UK pensions regime has gone through many changes; a period of stability and certainty are key for long-term growth.
• Annuity attractiveness is correlated with tax treatment. Annuity income in Australia is tax exempted, and similar breaks are present in the US. Regimes with high take-up rates of annuities offer tax breaks on annuity income streams. Annuity income tax relief up to a threshold could be a credible alternative in overcoming some of the more common barriers for consumers to buy the products in the first place.
• Minimum employer contributions review: the IMF and other institutions broadly support the need to raise contributions. An increase of the current 3% minimum employer pension contribution in the UK could ensure a minimum standard of living for citizens in old age. Interestingly, the Australian model includes a higher minimum employer contribution (9%) but caps it slightly above the median income level. This can help raise the level of pensions savings among those currently in lower incomes.

IV. Actions for firms
 

• Assess the firm’s product offering within the market and determine the ambition for growth across the current product suite.
• Identify gaps in product offering, consider what product combinations could best meet the growth ambition, consider capital, regulatory and operational costs and needs.
• Consider blending and phasing methods of product combination as integral to developing new commercial propositions. A more comprehensive product suite can act as a commercial differentiator and increase customer loyalty.
• Consider other products that include pooling arrangements and their potential impact for growth in the market. Should the firm decide how to participate in these markets, are they an opportunity, a risk, or both?
• Firms need to anticipate capital and funding needs and whether the DC growth strategy is compatible with current stakeholder expectations on dividend and revenue generation.
• Regulatory affairs and liaison teams can play a key role in analysing the impact of changes in policy and regulation in the market, and in liaising with policymakers to deliver better outcomes for consumers and the UK over time.

Conclusion
 

The pensions landscape in the UK is at a cross-roads and insurers have a significant role to play in it. Developing a framework to explore the range of products that can form part of the commercial proposition for DC pension growth should be a first step in this process. The range of products to explore should go beyond the tried and tested and include innovative options as well as new methods of combining products to meet the needs of customers better.

The policy and regulatory environment are the very air in which such a strategy needs to breathe and, as a result, firms need to consider how to anticipate and influence policy and regulatory change when implementing a successful growth strategy.
Product design and development is the first pillar of building a DC growth strategy. In our next and final article in this series we will focus on the remaining pillars: supporting customers/distribution and creating the right environment for growth.

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References:
 

¹ UK Life Sector Outlook Set Apart by Growth in Pension Risk Transfers (fitchratings.com)

² According to the National Centre for Social Research: 8% of people over 65 that responded to the British Social Attitude survey declared they were still working, and half of the survey respondents believed they are likely to continue doing some paid work after retiring from the labour market - source.

³ To date, Royal Mail Collective Pension Plan (RMCPP) is the only authorised CDC scheme in the UK. The DW&P has consulted on changes that could be needed to the existing single or connected employer CDC framework to accommodate whole-life multi-employer schemes.

⁴ As the annuity income is received in the drawdown fund for tax efficiency.

⁵ ALDAs are life annuities purchased via single premium at retirement.

⁶ Which? highlights that retirement advice on a pension worth £100,000 cost an average of £1,837. The median UK salary is £34,963 - assuming a 10% total contribution. With 0.01% of total salaries put in the advice pot for 45 years (~£35), the money saved would be £2430 without investment returns.