Retirement in depth

Your pension choices explained

Personal Finance and Savings

Those who save for a pension during their working lives can look forward to enjoying the fruits of their labours in retirement. This is especially true for anyone just approaching this landmark, as they will be among the first to benefit from extensive changes to pensions legislation. Designed to add flexibility to the way that retirement benefits can be taken, these new rules come into full effect on A-Day – 6 April 2006.

One of the attractions of building up a good-sized pension fund is the opportunity to withdraw a tax-free lump sum on retirement. Currently there are limitations on some types of pensions but from A-Day all savers will be allowed to take out at least 25 per cent of their fund tax-free to spend or invest as they wish.

The reforms will also increase your choice of how to use the remaining pot of assets to generate an income in retirement. Among the options that already exist are income drawdown and phased retirement, which we will deal with next month, but anyone seeking an immediate income with complete peace of mind will probably decide to use their fund to buy an annuity. Currently, on most pension schemes an annuity purchase is compulsory at or before age 75.

Cash for life

A pension annuity is like an insurance contract – in exchange for a lump sum, an insurance company guarantees to pay a regular income for the rest of the policyholder’s life. Tim Whiting, head of financial planning at IFA Bestinvest, says annuities are suitable for those who are not prepared to take too much risk as they enable them to lock into a known income.

Research by the Association of British Insurers (ABI) found that sales of annuities have almost trebled in the last ten years, from around 120,000 new contracts in 1994 to around 340,000 in 2003. It predicts that the market for individual annuities will rise from £7.2 billion in 2002 to £18.1 billion in 2012.

Compulsory purchase annuities are available to those with a personal or stakeholder pension and to the members of money purchase occupational schemes – although their choice of policy may be a little more restricted. But they are not relevant to anyone whose retirement income will be exclusively provided by a final salary pension scheme.

The minimum age at which someone can use their pension fund to buy an annuity will increase from 50 to 55 in 2010. An even bigger change, however, is the end of compulsory annuity purchase for all pension savers at 75. After A-Day, savers will instead be able to choose between an annuity and alternative secured pension (ASP), which is a way of keeping their pension fund invested and allows assets to be passed on for the benefit of future generations. This is attracting a lot of interest at the moment although some important details such as the inheritance tax treatment of lump-sum death payments under this scheme are still unclear.

Falling incomes

The enduring appeal of the annuity is that it is low risk, which suits most people of retirement age; there is, after all, a lot to be said for having the peace of mind of a guaranteed income for life. Most of the problems centre on a perceived lack of value when handing over what can be a substantial capital sum.

According to data provider Moneyfacts, at time of writing the best compulsory purchase annuity for a man aged 60 with £100,000 to spend would only give a fixed annual income of £6,198 for life.

When someone buys an annuity, the insurance company invests the cash in the safe haven of government bonds, and it is the histori-cally low yield on these that is responsible for dragging down annuity rates.

The other major contributing factor is increasing life expectancy, which means that the income will on average be paid out for longer. This is the reason why women re-ceive less than men – although the rates have converged recently, the equivalent annual income for a 60-year-old female is still only £5,813. It is also why anyone who can delay his or her retirement for a few years could enjoy a better income.

Shopping around

Many people wrongly assume they must buy their annuity from their existing pension provider, but more competitive rates may be available elsewhere. Peter Quinton, managing director of specialist IFA The Annuity Bureau, says it can make a considerable difference to take the open market option and shop around. “Only around 36 per cent of people actually change provi-ders, yet for those that do we have seen an average improvement over the last year of 12.38 per cent over all standard, impaired life and guaranteed annuity rate policies.”

Sean McCabe, annuity manager at IFA Chartwell Investment Management, says the recent announcement by Scottish Equitable that it is looking to re-enter the annuity market may be good news for savers who shop around. “One of the factors that drive rates is whether the insurer wants the annuity business. The return of Scottish Equitable will hopefully serve to make the market more competitive.”

Your choice of annuity is crucial since it determines your income during retirement. Once the decision is made it cannot be changed, which is why it is worth taking good independent financial advice.

Your choices

The range of options will increase after A-Day but currently there are four main types of annuity, namely: level, escalating, with-profits, and unit-linked. As the names imply, a level annuity pays a fixed level of income for life, while an escalating annuity either increases at a fixed percentage amount each year or is index-linked to increase in line with inflation.

Tom McPhail, head of pensions research at IFA Hargreaves Lansdown, says around 90 per cent of people opt for a level annuity be-cause the index-linked option means around a third less initial income. “The problem with a level annuity is that inflation will erode its value over time, but most people prefer to have the money now. But over 20 years an inflation rate of 3 per cent would halve the purchasing power of this income; the effect would be greater if inflation increased over this period.”

With-profits or unit-linked annuities work on the same principle as a conventional annuity, except that the underlying funds are invested in equities rather than government bonds, making them a riskier op-tion. “These are really for people who are prepared to sacrifice some income for capital growth, which typically means those with investments elsewhere who are not totally dependent on this source of income,” says Tim Whiting. “Linking your payments to any unknown outcome creates risk, but for those willing to accept this a unit-linked annuity would be the better of the two options.”

New developments

One of the main changes in recent years has been the growth in the number of impaired-life annuities. These are available to people whose life expectancy is shorter than average due to a medical condition or their lifestyle. The likelihood of a reduced payment period means these policies pay out a higher rate of income. “It is generally thought that up to 40 per cent of people could be entitled to some kind of impaired annuity, whether through smoking, diabetes, heart problems or the like,” says Tom McPhail. “It certainly makes sense to go for this type of option if you can.”

Impaired annuities are priced on a case-by-case basis but the uplift can be substantial. For example, the best non-enhanced level annuity that is available, at the time of writing, to a 65-year-old male with £100,000 to invest is £7,090 a year from Legal & General. The best equivalent impaired-life annuity for a smoker is from GE Life and is worth almost over a thousand pounds more at £8,080 per year.

A fairly recent innovation is the open annuity, which provides an investment-linked income and, on death, allows the value remaining in the fund to be passed on to the annuitant’s estate. Ken Wrench, chief executive of Open Annuities Limited, one of the companies offering this type of product, says that such an approach gets round the problem – associated with conventional annuities – of rates being dependent on government bond yields. “An open annuity gives more control over where the funds are invested,” he says. “By operating as a separate pot of assets, this enables whatever is left on death to be returned to the estate as a lump sum.”

Open annuities are higher risk than conventional annuities be-cause the level of income depends on the performance of the under-lying investments. They have to be bought through a financial adviser – see www.openannuity. net for a list of appointed agents. There may be changes to the product after A-Day but this will not affect any polices set up before then.

After A-Day, investors will also have the option of a new, limited-period annuity that will offer grea-ter flexibility. For example, a pension fund could be used to buy a five-year level annuity, with the remaining cash invested in unit-linked funds. After the five-year period investors can review their options.

Death benefits

One of the main criticisms levelled at annuities is that they represent poor value for those who die shortly after buying the policy; however there are various ways to protect the interests of the beneficiaries. Perhaps the key decision is whether to buy an annuity that pays until the death of the policyholder or until their spouse or partner also dies.

About a third of annuities are joint-life policies and entail a reduction in income levels according to the age of the spouse and the percentage of the original income they receive after the policyholder’s death. At the time of writing the best joint-life deal for a husband and wife both aged 65 that pays out 50 per cent of the income after the death of the policyholder is from Prudential and pays £6,570 a year, which is around £500 less each year than the best equivalent single-life policy available from Legal & General.

Unless it is bought on a joint-life basis, an annuity will normally cease payments on the policyholder’s death, although there is normally the option to guarantee the payments for typically five or ten years from the outset, even if you die in the meantime. Adding a guarantee will reduce the starting income and the older the policyholder the greater the cost. However, for a 65-year-old male the effect of doubling the guarantee from five years to ten years is marginal.

A-Day will see the introduction of a new value-protected scheme that guarantees to return to the descendents the balance of the money paid, namely the capital cost of the annuity less the income paid out until death, minus a tax charge. Sean McCabe welcomes the innovation but warns that the protection will come at a cost. “The jury is still out until we see the sort of rates on offer, but the advantage compared to a guaranteed annuity is the return of the unused capital as a lump sum, although the protection will only last for a maximum of ten years,” he says.

The changes inevitably mean that some people will find it more beneficial to buy their annuities before A-Day, while others will be better off deferring the purchase until afterwards. It all depends on the individual’s circumstances, which is why it is important to take advice. “For someone looking to maximise income it could be better to buy an annuity now rather than waiting as they would otherwise be trading certainty for uncertainty,” says Peter Quinton. “Alternatively, if the tax-free cash is important, some-one with additional voluntary contributions (AVCs) or protected rights who currently has no entitlement to this would be better off waiting until after A-Day when they will qualify for 25 per cent.”