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April 19, 2013 4:54 pm

Facing the annuity conundrum

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How to convert savings into income
A pensioner passes along the High Street in Southend, U.K., on Monday, May 28, 2012. U.K. retail sales fell the most in more than two years in April as record rainfall reduced demand for clothing and fuel sales plunged.©Bloomberg

Choosing how to convert accumulated pension savings into an income for retirement is one of the biggest financial decisions most of us will ever take.

But many of the estimated 650,000 men and women retiring each year are not making choices that will optimise lifetime savings for themselves and their families.

In recent years, options for taking pension income have widened significantly.

No longer are pension options polarised between the security of a regular income from an annuity and, at the other end, the risk of keeping funds invested in “drawdown”.

In the middle ground a raft of new pension products has emerged which offer pension savers, especially those with greater than average-sized pots, more flexibility and control over how and when they take their income.

But even as options are increasing, the majority of people going into reitrement opt for a lifetime annuity, despite annuity rates plunging to record lows.

With annuity income looking poorer value, some are now questioning whether annuities should continue to be the default option for those with above-average pension funds.

It’s all about choices

There are many different ways to slice the retirement pie. Here two financial advisers give their views on how a fictional couple could plan their income.

Christopher is 65 and has £200,000 in personal pension savings. He also has a £25,000 a year final-salary pension and qualifies for the full state pension, currently about £5,500 a year.

He is married to Mary, aged 62, and has two children aged 35 and 32 and two grandchildren.

There is a history of heart disease in his side of the family. The couple own their home outright. Mary has a small occupational pension of less than £10,000 per year.

Tom McPhail, head of pensions research, Hargreaves Lansdown

Tom McPhail

Christopher and Mary need to consider how much they need to live on in retirement, taking into account inflation and how much each would need should the other die first.

Is the combined income of their final-salary arrangements plus their state pensions enough to fund their lifestyle? I am assuming that Mary’s state pension will start to be paid shortly, since she is 62.

If it is, then I would suggest they defer drawing his personal pension as it is in a tax-exempt fund and, providing it remains untouched, is free from tax on death before the age of 75. He could tap into the fund at any time and, after taking 25 per cent tax-free cash, could use flexible drawdown.

In the event that he dies first, Mary will be free to use the fund to provide herself with an income and in the event that the fund is not drawn upon before she dies, it can pass to the children or other inheritors – although there will be a tax charge. Alternatively, if he is risk-averse, Christopher could use all or part of the fund to buy an enhanced annuity now to top up their income now or in the future. If they want some income now, then given the substantial secure income already available, I wouldn’t encourage them to buy more annuity income than they need.

Jackie Holmes, senior consultant, Towers Watson’s financial planning group

Jackie Holmes

If Christopher is a cautious investor and wants certainty over the income he will get, he should opt for an annuity. Even then, the difference between the worst annuity rate on the market and the best enhanced annuity rate, available if he has health issues, could mean several thousand pounds a year from a fund of £200,000. So, clearly, he should shop around.

If he is prepared to accept some investment risk, and particularly if he is happy that his and Mary’s existing pensions will be sufficient for their basic income needs in retirement, he could explore other options such as variable annuities or income drawdown.

Since he can meet the minimum income requirement of £20,000 a year from his current pension, he could opt for flexible drawdown. His pension fund will remain invested and he will have complete flexibility over what income he takes from it each year.

On his death, assuming he has not drawn down the entire fund, Mary could continue to take income or buy an annuity. Alternatively, a lump sum could be paid to her and/or the children (subject to a 55 per cent tax charge) so, unlike an annuity, the fund need not be lost on death.

We examine the alternatives to annuities and obtain advisers’ views on how they can work for you.


Fixed-term annuities

Short-term or fixed-term annuities have emerged as an alternative for savers reluctant to lock into a lifetime annuity at today’s record low rates. FTAs provide a guaranteed income for a fixed period of three, five, 10 or 15 years, which can be up to 20 per cent higher than could be generated from a conventional, comparative annuity.

At the end of the lock-in period, a guaranteed amount is paid. At this point, the investor may be in poorer health and qualify for an enhanced annuity. Various benefits typically associated with a conventional annuity can be added, at a cost, including a spouse’s pension if the annuitant dies, and capital protection.

The more benefits which are incorporated, the lower the level of starting pension will be. Fixed-term annuities are available for people with funds of £20,000 or more.

James Robson, independent financial planner at Plutus Wealth Management: These products mean you don’t have to make a decision as soon as you retire. But people buying FTAs must be willing to accept that their income could fall at the end of the fixed income period if annuity rates continue to fall.


Investment-linked annuities

An investment-linked annuity is similar to a traditional lifetime annuity in that it pays an income for life. However, instead of paying a guaranteed income as a result of being invested in gilts and fixed-interest securities, investment-linked annuities are invested in a wide range of investments, providing the potential for future income growth. They can be unit-linked, or “with profit” or fixed term.

David Smith, certified financial planner, Bestinvest: Investment annuities are also suitable for those who want the flexibility to vary their income periodically, perhaps to mitigate income tax.

The importance of providing a significant lump sum death benefit for spouse and/or children would be of secondary importance. Investment annuities are generally available for those with pension funds worth £20,000 or more.


Capped drawdown

This is also known as income drawdown and is where pension funds remain invested in the stock market or other assets. The term “capped” refers to the limit set by the government on how much income you can draw. Currently, it is 120 per cent of what could be achieved by buying an equivalent annuity.

Capped drawdown is also frequently preferred by those individuals who view leaving a lump sum to their spouse and/or children as a priority and/or do not want to make a definitive decision in terms of how to provide death benefits.

The fund size for capped drawdown is typically at least £100,000, and for small pension pots the costs can be very high.

Jackie Holmes, senior consultant, Towers Watson: Costs for going into drawdown have come down in recent years due to platforms and low-cost execution-only services. But you have to be comfortable taking the investment risk.


Flexible drawdown

Introduced just two years ago, flexible drawdown offers investors the ultimate in control over their funds, as there is no cash cap. But to qualify, an investor must have at least £20,000 in additional secure pension income, such as a final salary or state pension.

While any income taken will be taxed at the investor’s marginal rate, if the fund is not crystallised before the investor dies the lump sum can pass to heirs free of tax. Typically, you need a pension fund of at least £100,000.

John Lawson, head of policy, corporate benefits, Aviva: This is a good option which gives individuals flexibility to change their income levels from year to year.

Investors must be able to meet the £20,000 minimum income requirement.


Phased income drawdown

Phased or partial drawdown has become a buzzword in retirement planning and is the process of drawing on a fund in stages rather than all at once.

Phased drawdown can be particularly tax efficient, both in terms of death benefits and in the money taken from the plan, and can work with both capped and flexible drawdown.

Billy Burrows of the Better Retirement Group: In phased retirement, you cut a piece of your pension each year. Some use the tax-free cash for income and the balance is invested in either an annuity or drawdown.

One of the advantages is that if you die the untouched portion of your pension fund can be passed to your family without deduction of tax.


Don’t just maximise, optimise


“Optimise” rather than “maximise”. That’s the advice from pension experts who say that too often people in retirement focus on the annuity rate rather the “shape” of their benefits.

“There is no second chance when you are buying a lifetime annuity . . . you’re locked in for life,” explains Ros Altmann, an independent pensions expert.

“Shopping around is important, but many people aren’t making the right decisions when they need to take into account other factors, not just rate alone.”

The “shape” of the income includes considering how your spouse or partner can also benefit from your savings, inflation protection, and finding an annuity that pays more if you are in poorer health or smoke.

“Most annuities are bought by men and they are ‘standard’, single life and level,” adds Altmann.

“With annuity rates where they are currently, if the man dies within 10 years, he won’t get his money back. So understanding spouse cover, and partner’s cover, is important.”

Another consideration is preserving income against the ravages of inflation. Nine out of 10 annuities sold in 2011 were level and will remain frozen at this rate.

It is also possible to boost annual income by up to 40 per cent by shopping around for an “enhanced” or impaired life annuity which pays more to those in poorer health, or who smoke, because they aren’t expected to live as long.

Not all pension providers offer enhanced rates, so use your “open market option” to shop around – either by using an independent financial adviser, who will charge a fee, or an execution-only service, which takes commission.

“Enhancements” can be made for common conditions such as high blood pressure and diabetes and for smokers, but the biggest enhancements are for those with more serious illnesses such as cancer.

”If you are seeing a financial adviser, ask them if they are using the common quotation form to provide ‘full’ underwriting, because we have found that full underwriting leads to better income,” says Stephen Lowe of enhanced annuity provider Just Retirement.

New services that have launched online allow customers to search the market from the comfort of their laptops, but still charge a commission of up to 3.5 per cent, in some cases, for a sale that is unadvised.

“There can be a lot of pitfalls to buying without advice, from not quite getting all the right medical information to enhance your rate, to not getting the right shape of the annuity,” says Bob Bullivant of Annuity Direct, an independent financial adviser.

“You also need to understand that if there are benefits to keeping your pension with your savings provider, rather than buying elsewhere, such as if you have a guaranteed rate. Unless you really know what you are doing you should proceed with caution when buying direct.”

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