About GARs and GIRs

Adrian Howard-Jones, Sunday, 29 October 2000

1 It seems the problem is about how GAR policies were managed.

2 The press has it that the Equitable were cheating GAR policy-holders of their due. Simple as an idea but is it true? Understanding the policies is not made easier by the quasi-legalistic language in which they are written. It was even a challenge for the Courts to decipher the meaning of just a few pages of pension policy.

3 So what are the GAR Policies? These are policies issued before 1988 that, in effect, combine an investment plan with insurance policies which provide two guarantees. The first guarantee (in common with many non-GAR policies) is a guaranteed minimum growth rate (described as a GIR Guaranteed Investment Return by the Society). The second guarantee is a guaranteed minimum annuity rate (known as a GAR Guaranteed Annuity Rate). Example reference policies give the following levels of annuity.

4 Policies described as non-GAR policies were issued after 1988. These policies are distinguished from the GAR policies in that there is no guaranteed rate for annuity offered in these policies. The policies did however contain GIRs. However, it is understood that the latest policies offered contain neither GARs nor GIRs.

Table shows GARs and GIRs for two example policies.

5.GARs and GIRs are not all identical, and rates should be determined from the Policy booklet. The table also shows the range of current annuity rates of the top ten providers. It will be noted that the market supports a surprisingly wide spread of annuity rates. In the three classes considered there is over 13% difference in rate between the highest paying provider, and the tenth highest. It will noted be that the GAR policy is now worth between 22% and 27% more that the very best open market rates (depending on which of the 6 categories given above is applied).

6. Example

6.1 To give just one example take the case of a 55 year old with a (226) with profits retirement policy who contributes £1000 today with a view to retiring at age 60.

6.2 Application of the GIR results in a guaranteed accumulation value of A = £1134.20 after 5 years. The GAR at B =10.32% will result in an annuity of: 0.1032 x £1134.20 £117.05 per annum when applied to the guaranteed policy value without the addition of any bonuses. The GAR is about 23% above the market rate (see table above). The guaranteed cost of the annuity to be purchased (if open market annuity rates remain stable) will be: 1.23 x £1134.20 £1393.=96.

To achieve this guaranteed growth in 5 years requires an average annual rate of return of 6.85% on an investment of £1000. The yield on a typical Gilt with maturity of about 5 years is currently about 5.5%. Longer-term maturities have got lower yields, just under 5%. Therefore it is not possible to fund the contractual obligation purely with Gilts in today=92s market unless a greater value of Gilts is purchased than that of the original premium.

In fact, if the return is fully secured it would be necessary to purchase Gilts today to a value of about £1100.=96. The whole of this purchase would then need to be dedicated exclusively to satisfying the GAR. No profit other than the contractual due would arise. Note: the need is to buy Gilts capable of providing a sufficient cash flow to support the eventual annuity. It is not enough to provide cover to the forecast cost of the annuity by purchasing early maturing gilts to provide £1393 in five years time; if interest rates fall further the costs of annuities will continue to rise.

6.3 The £100 additional to the premium paid would need to be derived from other sources, as for example from a general fund to which no additional contribution has been made.

7. The “GAR” policies produce a guaranteed minimum yield from each contribution. The minimum annuity benefit in the hands of the new retiree is therefore guaranteed for every separate contribution (as illustrated above).

8. However, this guarantee is not cost free, and the cost of the guarantee climbs steadily as market interest rates fall. In order to meet the terms of the guarantee with security and to satisfy the regulations for “resilience” which apply to guaranteed obligations; it is necessary to progressively increase the proportion of the underlying fund invested in low yielding Government Stock. It follows that when interest rates come down; the GAR policies need to be substantially invested in low yielding secure stock, which provides relatively little growth. This contrasts with the non-GAR policies where a greater freedom for investment exists. Under the conditions of recent years with strong rises in the stock market, the investment pool necessary for non-GAR policies would therefore lead to the expectation of greater profitability, than the equivalent pool for GAR policies. The situation of the GAR policyholder is therefore closely analogous to the investor who invests in a Building Society deposit account in comparison with the less cautious investor who invests on the Stock Market. In recent years the investor who has invested consistently on the Stock Market will have seen a growth in funds much greater than that of his more cautious colleague.

9. Next it useful to compare the values of the annuities which are secured by the GAR and the non-GAR policyholders. Any forward cash flow can be evaluated to determine the Present Value. The Present Value is the capital sum that, under the prevailing market conditions, is seen as being immediately equivalent to the prospective cash flow. It is calculated systematically by applying a discount rate. The discount rate is linked closely to the current interest rate. Annuities purchased in the open market are priced having regard to tables of mortality and the current discount rate (as well as any fee taken by the provider). Any particular forward cash flow can only have one Present Value. It follows therefore that working from an actual capital sum there is only one annuity rate that can be applied. This is the current market rate.

10 However, we are now in a situation in which there is a guaranteed rate that exceeds the market annuity rate. This is the only condition under which the guarantee provides a greater value under the policy. Therefore, it follows as a mathematical certainty that it is not possible to purchase or fund an annuity at the guaranteed rate on the basis of an actual capital sum. However it is done, the guaranteed annuity is always calculated on a nominal sum, not an actual sum. In this respect there is a major distinction between GAR policies and non-GAR policies. For the former the yield is necessarily calculated on a nominal sum, for the latter it is calculated on the actual sum (it is applied at the prevailing market rate).

11. It has been noted above that the GAR policies are inherently less profitable under the present market conditions than non-GAR policies. Therefore it would be expected that the actual value of funds available for the pensionable sum for a GAR policy would be less than that expected for a non-GAR policy. As demonstrated above, the GAR policy values involve the calculation of a nominal policy value. The nominal value will always be less than the actual value in the instance when the guaranteed rates exceed the market rates. It follows that the equitably expected growth rate of the nominal value of a GAR policy under the current market conditions will always be less than the growth rate of the actual value of a non-GAR policy. This involves two areas of difference, one is the difference in investment performance, and the other is the difference between a fund that is operated with respect to nominal values, versus a fund, which is administered with respect to actual values.

12. However, the GAR policies as written have other properties. The Equitable attempted a policy of allowing the holders of GAR policies access to the actual value of the funds if they wished to take the open market option. This gave the GAR policyholders a right that they did not have under the terms of their policies. They were only entitled to receive a sum corresponding to the nominal value. The principal ruling of the House of Lords covers this point. However, whereas the GAR policyholders thought that they were being cheated of value by the alternative pensionable value offered by the Equitable, in fact they were being offered a greater value than they were entitled to when they took the open market option. The same applies to death before pensionable age, where actual rather than nominal sums were paid to estates, again a greater level of payment than the policy offered.

Basing all payments on the nominal value produces some surprising outcomes, but a moments thought will lead to the conclusion that, properly administered this did potentially provide additional streams of cash to sustain the nominal values of the policies. In other words, if (when GAR rates exceed open market rates) the GAR option were not taken up either because of premature death, or because of the selection of another option, there would be a release of capital back into the fund. This release would be a sum corresponding to the difference between the nominal value paid out, and the actual value held against that policy.

13. In fact, in the administration of the policies, it seems that the Equitable has disregarded entirely the differences in investment strategy implied by the GAR policies. Further to that it has paid out sums greater than the contractual due by allowing the actual value rather than the nominal value under the policy to be applied to the open market option. While claiming to be fair, the Society has in fact been grossly unfair to the non-GAR policy holders by failing to recognise the greater profitability of policies unencumbered by guarantee, and by making payouts at greater than the amounts due under the GAR policies.

14. The irony is that the mistake that the Equitable made was that of excessive generosity to the GAR policyholders, crediting a greater share of the profits than due, and allowing greater payments than sustainable from the terms of the policies. It appears that the courts did not understand this. The effect of the House of Lords judgment, as interpreted by the Equitable, is to allocate an even greater payment to the GAR policy holders by insisting that the nominal values attributed to the GAR policies should be subject to the same bonus rates as the actual values attributable to the non-GAR policy holders. This serves only to exacerbate the unfairness experienced by the non-GAR policyholders.

15. In the meanwhile, there are those who perceive a “spouse” issue. Much of the GAR risk is written in terms of single life policies. Taken in this way a higher value annuity is obtained than if the open market option is taken. Some of these policyholders wish to extend this higher value to apply the actual (rather than the nominal value) to purchase an annuity in joint lives with their spouses. This can of course be done, but it would have the effect of ratcheting the value of their open market option above that of the equivalent non-GAR policy. However, it is perhaps inevitable, that having secured the ruling that the Society can only attribute a single value to a policy, whether nominal or actual, there are those who wish for an outcome that would reverse this situation!

16. To return to the start, were GAR policyholders being cheated of their due? Absolutely not! But the management strategy adopted by the Equitable made it seem as if it was so, even though the payouts actually being made were in many instances greater than those due under the terms of contract. So what went wrong in the courts? Were the issues of the non-GAR policyholders considered rationally? Or was it the case that this should have been a three cornered argument? Aggrieved GAR policyholders, whose policies were not being correctly administered, confronted a company that had a primary interest in defending its management strategy. As shown above this strategy was neither reasonable nor equitable when considering non-GAR policyholders. No one was there to represent the specific interests of the non-GAR policyholders. However, what happened in the courts is another issue.

17. In respect of new contributions it appears to be the case that the GIR and GAR policies were heading inexorably to crisis as interest rates fell however the funds were managed, and whatever the decision of the Courts. This is because the guaranteed rate of return exceeds the rate on secure funds available in the market place. It is possible that in a few years time the GIRs alone will also prove difficult to fulfil. At 3.5% the GIRs are set above interest rates currently prevailing in Japan, and higher than prevailed for many years in Germany. Present long term Gilt values point to an expectation of a continuing fall in the levels of return.

Note:

24/10/00, 29/10/00

Alistair Dunbar of the Equitable has had sight of this note in a version as drafted on Monday, 16 October 2000. This version contains a number of minor adjustments. The views expressed do not coincide with those of the Society so he does not feel that he can comment. He is aware of EMAG's intention to publish the note.