Decisions, decisions...
1 Jul 08
Stephanie Hawthorne offers a guide to the hows and whys of pensions, the choices to be made and the sources of help and information
by Stephanie Hawthorne
Shakespeare’s King Lear feared the worst: “…and, squire-like, pension beg to keep base life afoot”.
Thankfully, the outlook is a little brighter in modern times. So how to cope against market volatility and penury? One solution is to take out pensions (or segments) with different maturity dates to mix and match the annuity and to avoid bear markets.
For people who did not save earlier, there is the safety net of the state pension of £90.70 a week but this net would not pass a stringent health and safety check. A visit to a Premier League football match would almost wipe out the entire week’s allowance. Nevertheless it is useful as its receipt triggers many other benefits.
At retirement Personal pension holders and people with defined contribution pots can receive 25 per cent of their retirement fund as a tax free lump sum. The balance, 75 per cent of the personal pension fund, must normally be used to buy a compulsory annuity. Trustees must have a process in place to convert a member’s money purchase fund into a retirement income. For many, feeling like millionaires, with large retirement funds, the meagre size of the annuity will come as a shock.
A retirement fund of £100,000 will typically buy a male aged 65 an annuity of £7,543 (no escalation) £5,512 (rising by 3 per cent a year) and a female would get £7,040 (no escalation), £5,053 (escalating at 3 per cent a year).
The amount that you receive from a conventional annuity depends on several things: age and health (how much longer you are likely to live), interest rates and the size of the pension fund. Also ask yourself whether you need an annuity with or without a pension for your widow or widower. Currently 81 per cent of married men choose to buy single life annuities. Is this fair on the partner?
The open market option
The annuity market has tripled in size in the last 15 years with 400,000 new contracts in 2007 totalling £11billion in premiums. If you are getting a pension from an occupational defined contribution pension scheme, the trustees may buy your annuity but you can also shop around using the open market option. Take time over this – as Mike O’Brien, Minister for Pensions Reform, says: “Choosing the right annuity is one of the most important decisions a person will take in their life.” This is because there is virtually no chance of changing your annuity provider for the rest of your life.
There is a large difference between the rates offered by companies, sometimes as much as a third between the best and the worst, and people with impaired lives can get up to 100 per cent better rates. Indeed research from London-based Partnership Assurance shows that British retirees are losing out on £1.25billion worth of pension benefits by failing to seek professional advice to find out how health can influence annuity rates.
About half of consumers simply accept the annuity offered by their provider without shopping around for the best deal. Furthermore, the independent financial adviser (IFA) firm Hargreaves Lansdown claims 40 per cent of people are probably entitled to enhanced annuities for ill health though only 9 per cent claim. Smokers can also get enhanced rates.
It is more than five years since pensions providers have been compelled to inform policyholders of the existence of the open market option but disappointingly the numbers making use of it on retirement have been relatively static. Perhaps one solution would be to make the open market option the default option so that people have to shop around.
What’s on offer
Nearly every life office offers a level annuity where payments are fixed. This is the most common type but an immediate high income may mean poverty in the longer term with inflation eroding the value of income.
More risky are unit linked annuities where the monthly payment varies with unit prices. Here, payments may go up as well as down and the starting level will be lower. A unit linked annuity should not be the sole source of income in case the unit price suffers a bad fall in value.
Payment from a with-profits annuity depends on bonuses being maintained. Annuities can also be linked to the Retail Price Index. Some annuities escalate by a fixed amount each year. Annuities can be guaranteed for five or 10 years even if the person taking out the annuity has died in the meantime, or they can be be “capital protected”, where the total payment is guaranteed to at least equal the amount you put in. In either case, if you die before that has happened the money goes to your heirs, but there is a price for these guarantees.
Additionally, some older pension contracts may have guaranteed annuity rates in retirement. These can be much higher than the prevailing annuity rates so check with your pension provider to see if there are any with your pension.
If the annuitant’s health is poor, a higher pension rather than an escalating unit linked one might be more suitable and a guarantee that payments will continue for a fixed length of time is also essential. People from long-lived families might find the escalating pension is the better bet or for the more adventurous, unit linked or with-profits.
Another option is personal pension income drawdown where the purchase of an annuity is postponed and the policyholder siphons off income from his retirement fund. It gives greater choice and flexibility but if you need to draw the maximum allowable income from your fund, income drawdown is not for you. It could be suitable for people with pension funds of more than £200,000.
The Government Actuary’s Department produces tables of annuity rates, on behalf of HM Revenue & Customs which are used to calculate the maximum income which may be withdrawn from unsecured pension funds and alternatively secured pension funds (otherwise known as income drawdown or income withdrawal) on its website. The holder is free to buy a conventional annuity at any time when rates are favourable and any balance must be used to buy an annuity by the age of 75.A widow/er can continue this arrangement. The fund is reviewed every three years by the pension provider.
Time for reform
Insurance companies are not as efficient as they might be in processing funds. Nick Flynn of IFA Origen says: “Clients simply do not understand why it takes six weeks to get their pension. We write to clients and tell them it takes six to 10 weeks and most of our complaints come because of that letter.” When it comes, the quote guarantee may only last 14 days. Nigel Callaghan of Hargreaves Lansdown points to the “maddening experience of annuity rate changes mid-way throughout the process which can leave the investor feeling short changed”. Typically there can be eight to 10 rate changes a month.
It is also unsatisfactory that it is compulsory to convert the retirement fund to an annuity by the age of 75 when there are so many glaring problems. Clearly there is a public policy case for compelling people to have annuities which are at least equal to minimum income guarantees but above that there should be freedom of choice and tax could easily be clawed back if over paid.
Then there is the question of discrimination against women. While they live longer than men, their living expenses are similar. Is it fair that two employees aged 60, one male and one female, may get pensions that vary by as much as 5 per cent a year?
In the US and Canada any annuity bought directly with the proceeds of an employer sponsored defined contribution pension scheme must be unisex. In 2012 personal accounts will generate up to eight million new pension savers who will ultimately need annuities, so the need for reform is urgent.
STEPHANIE HAWTHORNE is Editor of Pensions World