The UK’s annuity market – currently valued at £12bn a year and expected to treble in size under auto-enrolment – is on the brink of “failure”, warns a report published today by the National Association of Pension Funds and the Pensions Institute.

The report, Treating DC Members Fairly in Retirement, highlights systemic flaws in annuity pricing and rate transparency. It claims there are insurmountable barriers to using the open market option (OMO) for DC scheme members, particularly for those with smaller funds. As a result, annual cohorts of annuitants lose an estimated £500m-£1bn of aggregated lifetime income.

There are 4.7m employees in private sector DC schemes: 5m-8m more will join under auto-enrolment, which begins in 2012. With the financial security of future private sector retirees at stake, government intervention in the market is inevitable, the report says, unless the pensions industry undertakes root and branch reform to ensure all members secure the right type of annuity at the right price.

Insurance companies that operate in both the scheme and annuity market benefit most from the current system and retain up to 86 per cent of DC customers at retirement. The Association of British Insurers wants insurers to promote the OMO more explicitly, but the report asks whether the companies that profit from the status quo can drive through the necessary reform.

For members, DC schemes represent an illogical and disconnected journey. The accumulation stage is based on an institutional asset management model designed primarily for the “default” member, who does not make active decisions.

Defaulters account for 80-90 per cent of members; they rely on the default fund for the entire accumulation process.

The success of auto-enrolment is predicated on high levels of member inertia. Yet at retirement, the member is expected to select a long-term retail insurance product – the annuity – a process that requires an above-average level of literacy and numeracy and an understanding of inflation and morbidity trends. For the defaulter there is no learning curve for this one-off irreversible decision.

The regulation of annuity sales in the DC scheme market is irrational: the Financial Services Authority regulates contract-based DC, while The Pensions Regulator regulates trust-based schemes. The report urges the two regulators to agree on a single set of simple rules for non-regulated advice in the workplace, so that employers and trustees can be more pro-active.

The regulation is also weak: the only requirement is that members are given basic information – a leaflet will do fine, but even these are flawed. The FSA and TPR annuity leaflets describe the OMO and the (highly complex) advisory system. They direct members to adviser websites that use postcode search engines, which do not locate specialist advisers that offer a cost-effective service for smaller funds.

Most independent advisers will not take on clients whose fund value is less than £30,000, unless they have other investable assets.

This threshold is expected to rise to £50,000 in 2013, when new rules for the advice market are introduced.

This will exclude about 80 per cent of DC members from full advice. Nevertheless, the cost of commission for advice – typically 2 per cent of the fund – is factored into most annuity rates, so members pay whether they take advice or not.

Overall, therefore, the report found that the annuity system for DC schemes endorses the inappropriate transfer of risk from the “knowledge community” of employers, trustees and providers, to those least capable of making informed choices.

A key finding of the report is that annuity pricing lacks transparency and conceals “anomalies”. A common practice is rate manipulation, whereby scheme providers drop their rates in anticipation of a substantial tranche of DC member funds reaching maturity.

The report also found that “enhanced” rates offered to members with poor health or lifestyle conditions can be poor value and worth 15 per cent less than the top OMO standard rate.

Unless the FSA introduces benchmark rates, the term “enhanced” will remain misleading, and is likely to trigger a mis-selling scandal.

Even where enhanced rates are secured through the OMO, these are “underwriting-light”: they provide only a percentage of the potential uplift because the underwriting is based on a simplified, rather than a full medical questionnaire.

These transparency and pricing issues are unlikely to be tackled under current regulation. Section 348 of the Financial Services and Markets Act prohibits the FSA from publishing “confidential information”, unless it has the insurance company’s consent.

One way to circumvent these problems, the report says, is for the government to require all schemes to provide a default member support service, which actively helps members to choose the annuity type and then makes the purchase in the open market. This model is already being used by contract- and trust-based schemes at no additional cost to employers.

If the industry does not reform voluntarily, the report recommends that the government replicate in the annuity market the process it has introduced for accumulation through the National Employment Savings Trust (Nest), which was designed to correct a market failure in relation to low-to-median earners, who are not served well – or at all – by private providers.

Debbie Harrison is a senior visiting fellow of the Pensions Institute at Cass Business School.

To contribute to the debates raised in this series go to discussions.ft.com/alchemy or email dr.debbie.harrison@gmail.com