This article was originally commissioned and published in June 2013 for Investment Life & Pensions Moneyfacts publication. Tom Murray, Head of Product Strategy at Exaxe, argues that a return to the basics of addressing protection needs would benefit those clients on smaller incomes the most.
Return to basics will benefit those on smaller incomes
"It is a terrible thing to be an unprotected being”, Colm Toibin writes in The Master, his biographical work on Henry James, and it is a concept that most people can identify with. The need for protection in the midst of a chaotic world is a primary need that has been a key driver for the evolution of our society.
It was in answer to the financial aspect of this need for security that the life and pensions industry was created. The original purpose of the sector was the provision of protection products, products that protected people from the risk of loss rather than promising them any gains.
Yet over recent decades, protection products have faded in popularity, as people sought more immediate solutions for their need for security by seeking to invest their money in order to build up sufficient savings to give them that financial security they needed. The value of pooling risk and seeking protection from a group has faded as individualisation in tandem with globalisation has become the current fashion.
Lured by the promise of enormous gains that can be made by investing in the stock and money markets, the general population has shunned the boring nature of protection products and moved to trade in lucrative overseas investments. The fact that many of these have turned out to be bubbles has not dampened peoples’ enthusiasm for these investments. The ubiquity of technology to access these markets has made the situation worse as it is far easier for people to gather information about investments that would previously have been out of their reach but it is also easier for the herd mentality take over, which causes trends and stampedes both up and down that bear no relation to the underlying information.
This is very dangerous for lower earners as investment markets are fundamentally more suited to those who can sustain some level of loss and ride out reasonable downturns to benefit from the inevitable upturn.
Suitability has been forgotten
These are difficult times for the majority of the western world. Economic growth is hovering around zero per cent in most industrialised countries and unemployment is either rising or plateauing at a very high level. In the UK, the economic prognosis is positive but patience is needed, as it will take many years for the country to pull itself out of this particular slough of despond.
In this environment, the chance of getting high growth return on investments is relatively low. Yet, without high returns, small investors will not see sufficient growth in their funds to provide them with any future security at all. Why, therefore, are they being advised or led into investing when there are more efficient ways for them to provide the security and stability they need without taking such risks with their money?
Risk / Reward is too low
The essence of the problem is that the majority of savers now being nudged into the market by the government are small savers with low to middle income earners that cannot afford to lose what little they have to save. They also are those in need of the highest growth figures, as without strong growth, their savings will never amount to very much.
With the popularity of ISAs and the auto-enrolment push into pensions, this is exactly where the majority of the low to middle income earners are heading. Their savings will accumulate and grow at very low rates giving a level of protection to their lifestyle that is extremely low in comparison to that which could be achieved by pooling resources but individual greed and the desire for personal ownership has blinded people to their own real interests. Is this really the best that the financial services sector has to offer people?
Protection products to the rescue?
The world of protection products has become a sleepy backwater amid the investment excitements of the last few decades. Fashions come and go and since the deregulation of the financial services sector since the 1980s has ensured that it has been investment products that have been ‘trending’, to use the vernacular.
Since protection plans have gone out of fashion, little is heard of them in the media. Every commentator seems focused on how to achieve the almost impossible task of turning small contributions into something that would deliver financial security for the individual.
This is madness as there appears to be little hope of ever getting people to accumulate enough to guard against the risks of financial problems. In fact, that was the whole point of the invention of life assurance in the first place – to provide security for people against unforeseen circumstances.
It was designed so that people who did not have the resources to withstand a calamitous event could pool their money as it was unlikely that everyone would suffer the same event at the same time. In terms of the ordinary family, the primary risk is the death of the policyholder
It’s time to change the record.
The revival of protection should be the big news story of this decade. We need to re-spark interest in protection as a far cheaper way to give people security. Protection offers the ability for people to protect themselves while still leaving them some ability to save and/or spend. Unlike constant saving, the lower amounts required for protection products means that the spending power of individuals will not be as heavily reduced, which will be good for the economy as a whole.
One of the reason pooled risk went out of fashion is that the idea smacks too much of collectivism, so last century! However with the rise in broader concerns beyond themselves, such as climate change, equality and human rights, the general populations’ interest in collective action is rising again. This should mean that the average person becomes less averse to the whole idea of pooled risk and starts to see the value of the traditional life assurance products as a key part of their financial product portfolio instead of the poor relation that it currently is.
Even in pensions, where decumulation products are now seen as of equal importance to the initial pension accumulation products, there is an obsession with moving away from the traditional pooled nature of annuities in order to get something more individualised. The problem is that individualised solutions are by their nature risky and the risk rests completely on the shoulders of the individual who gets no help from anyone else if anything goes wrong.
The obsession with getting individual value by encouraging people to think about guarding themselves against dying early in the annuity just reduces the amount of protection those who live longer than the average can have. Similarly, the trend towards flexible annuities and drawdowns increases the idea that the primary issue for people in the decumulation phase should be preserving the wealth for the individual to pass on rather than pooling it to ensure that the highest level of income is provided for all annuitants. Very Ayn Rand but not really useful for those whose savings in the first place do not amount to the significant levels that are required if they do live out a lifespan beyond the average.
Protection provides far better value for money for lower-income individuals. The capacity to insure their life cheaply ensures an amount for surviving dependents to live on in a far more effective way than any investment could do because it draws on the pool rather than on the individuals.
Industry drive is needed
This is the time when the original purpose of life assurance comes back into play. The fact that many people cannot afford to save enough to protect themselves from the risk of longevity in the first place means that conventional annuities remain their best bet, unadulterated by guarantees for return of money in case of early death to their estate. The point of pension saving is to provide income for the rest of your life but in a foolish attempt to maintain an inheritance, people are reducing the already paltry amounts provided even further by buying guarantees, afraid that otherwise the insurance company will get the lot.
They don’t realise that it is the other annuitants that get the money. It is never brought home to them that the point of pooling is that based on the fact that not everyone will live above the average age, the pool maximises the amount each individual can be guaranteed and it is this guarantee that gives the financial security desperately sought by so many people. Why are companies and the media conspiring to keep this obvious fact away from people?
Indeed it is already clear that this approach of appealing to the individuals desire to keep all their own money and the inbuilt hope that they won’t be the one to die is ultimately going to lead to justifiable claims of mis-selling in future decades. The amounts saved by individuals will fail to deliver sufficiently to the level of promises that they are being given but will deliver significantly more fees to the industry than more suitable protection products would have.
Dangers of misselling
Of course, one has to be suspicious of the amount of people who are pushing individualisation and individual savings. Many people were missold personal pensions when they first opted out of SERPS, the problem is that far more people stand to gain from individual investments with charges generally at a much higher rate as people switch in and out of funds and the large volume of transactions have to be paid for out of the totality of the savings pots.
In contrast, large protection funds can employ economy of scale and long-term strategic investment planning to minimise costs and provide the maximum benefit to the contributor.
Rebirth of protection
The time has come for protection products to re-assert themselves. For many, the pooled collectivist approach is the correct one, no matter how old-fashioned it may sound. If we can get advisers to move away from the trendy approach of selling flash investment products and really look at the needs of clients then protection products will make much more sense for them. The retail distribution review (RDR) has supposedly separated advice from the type of product sold so there the products sold would be more appropriate for the client. For lower-income clients, therefore, we should see a big increase in the number of protection products sold both because of their greater suitability in many cases and because commission is still available on these products, although for how much longer it is impossible to tell.
People need products which are more suitable for their needs. It is time to get back to the original idea of providing security by pooling resources to protect against risks going bad. Protection products need to be dusted off and moved to the front of the shelf again, if we are to provide value to our customers – and what else is the industry about?