About unit-linked guarantees
In simple terms a unit-linked guarantee is a unit-linked investment that has a guaranteed benefit attached to it. There are two primary components to a unit-linked guarantee: an investment in a mixture of equities, bonds, cash and other assets, and an insurance policy overlaying this which protects the retirement income or capital value from any falls in equity prices.
The guarantee can be for income, the capital value or a combination of both. In addition, all policies normally offer a guaranteed death benefit. The unit-linked investment can be inside or outside of a pension wrapper but the vast majority are pension policies (sometimes called ‘guaranteed drawdown’ policies) which have a guaranteed income option.
The advantages of unit-linked guarantees
- They can pay a guaranteed income for life whilst maintaining flexibility and control over the pension pot (guaranteed drawdown)
- A range of capital and or income guarantees with the potential to benefit from any future investment growth
- Potential for the guaranteed income to increase if income is deferred
- Allowing investment gains to be locked-in via the income or capital guarantee options
- Guaranteed lump sum death benefits
- Confidence to remain invested in equities in the knowledge that if there is a stock market crash the capital and/or income is protected
- The ability to plan ahead with the knowledge that a certain level of income is guaranteed
- Flexibility to change future retirement plans if circumstances change
The critics of unit-linked guarantees point to the following disadvantages:
- The guarantees may appear to be expensive
- The guaranteed level of income is low compared to annuities
- If fund values fall soon after policy is taken out, it might take a long time before the policy is ‘back in the money’
- Some argue there is no need for a guarantee in the first place
I will discuss all the advantages and disadvantages in order to present a fair and even handed analysis.
In order to understand the benefits of ULGs it is necessary to understand the following:
- Income guarantees
- Capital guarantees
- Guaranteed death benefits
- Dynamic hedging
This is perhaps the best known feature of unit-linked guarantee policies. A minimum level of income is guaranteed to be paid for life, whilst maintaining the flexibility of drawdown.
This is why these policies are often referred to as ‘guaranteed drawdown’ policies. Typically income can be guaranteed immediately or deferred for a number of years.
To understand how the income guarantees work it is necessary to know about three features; the income base, the guaranteed income percentage and the investment lock-in.
Income base: This is the notional fund value which is used to calculate the level of any guaranteed income that is payable. It is calculated periodically and is based on the value of the fund at that point in time.
Guaranteed income percentage:This is the factor that determines the level of guaranteed income. Each company provides their own table of rates which shows the income factors currently available. There are normally different income rates for single and joint life options.
Investment lock in:At the income review date, if the highest recorded fund value is greater than the current guaranteed income base, the policyholder’s income will increase proportionately. The precise method will vary by provider, but this review will occur at least annually.