It is important to take proper care and consideration with retirement planning, because your pension is likely to be your second-largest asset after your home and certain pension decisions cannot be reversed. One of the biggest such decisions is now whether to buy an annuity, as the obligation to do so has been abolished.
For most people without substantial savings, buying an annuity is the right choice – it provides a guaranteed income for the rest of your life, but it is vital to check the market for the best rates.
If you have impaired health, and suffer from, say, diabetes, providers will offer you an enhanced deal, up to 30 per cent more than for those in better health. You can also achieve favourable terms if you smoke or if you have a condition such as high blood pressure or cholesterol.
The biggest drawback to an annuity is that when it is based on just your life, payments cease completely when you die. But annuities can be purchased on a joint-life basis so that they continue to be paid to your spouse on your death.
A new factor to consider is the European Court ruling on 1 March to ban UK insurance firms from gender-pricing annuities, which will cut annuity income for men by up to 13 per cent, as they live on average four years less than women. Currently, annuities are tailored to male and female life expectancy. The final deadline for the change is 21 December 2012, so it may be beneficial for men who have some flexibility around when they retire to annuitise before the rates become unisex.
Long term, however, options such as investment-linked annuities or pension drawdown will prove far more attractive for men. Annuity rates will be further worsened by another EU initiative, Solvency II, which will come into effect in two years, and will force life companies to value their annuity liabilities using government gilt rates, rather than the corporate bonds currently used which offer better returns.
This will produce lower annuity rates across the market, by as much as 15 per cent, according to Philip Steel at The Annuity Bureau. He says the rates on offer by Prudential and Scottish Equitable have already dropped, but Aviva, Legal & General and Canada Life have so far maintained their rates.
As part of the rules scrapping annuities, pensions can now be used to pass assets to your heirs free of inheritance tax, subject only to a 55 per cent ‘recovery charge’ intended to recoup the cost of front-end tax relief on contributions. This is a big improvement on the previous regime’s penalties, which could be as high as 82 per cent once unauthorised payment charges were added to IHT.
The rationale for the recovery charge is simple: if you take 25 per cent of an imaginary £100,000 fund as tax-free cash, then the new charge of 55 per cent on the remaining £75,000 works out at 41.25 per cent of the original £100,000, a little more than the initial relief high earners receive.
For investment-linked pension income, there are two new income drawdown options – capped and flexible. Under both you can choose to take no income, and tax-free cash can be paid at any time after the age of 55.
The ‘unsecured pension’ rules, which allow cash withdrawals subject to annual limits, will continue under the new capped rules; but the amount of drawdown will be limited to 100 per cent of the relevant annuity calculation derived from the Government Actuary’s Department tables, instead of the 120 per cent applied before 6 April 2011.
However, the flexible option allows room for manoevre beyond capped drawdown. You can draw unlimited amounts from your pension so long as you have secured a separate income of at least £20,000 per year, known as the
minimum income requirement. This must comprise of guaranteed payments, such as income from pensions.
It is a ‘once-only’ test, no matter how often you use the facility, and the Treasury has indicated it will allow level annuities to be included in the calculation. Withdrawals can then be taken at a time that best suits you – ie. when you are at your lowest tax rate. It might even be possible to make large withdrawals if you move to a low-tax country.
But providers are having a tough time putting in place systems to offer the new drawdown facilities. Major insurers such as Scottish Widows and Aegon did not offer it when the changes took effect in April. Aviva is only offering flexible drawdown to Sipp customers, while Scottish Widows has called for advisers to be cautious about recommending flexible drawdown until the FSA issues best practice guidance.
This means savers with those companies who want to use flexible drawdown to withdraw large sums are being forced to make transfers to other providers, which may involve additional fees.
Another consideration under the new regime is that compulsory annuitisation has always driven a cautious approach to investing in the last few years before the annuity purchase, with a gradual switch to low-risk bonds and cash.
Now that you will not be forced to irrevocably convert your savings into an annuity, you will be able to keep your investments in higher growth assets, including volatile assets such as equities.
The rise of scheme pensions
People in ill-health have the option of the oddly named ‘scheme pension’, which sets income based on life expectancy. This might appeal to men under the new unisex annuity regime.
The level of income drawn down is based on the individual’s own life expectancy, taking into account their age and specific health problems, the size of the fund and the investment strategy. These amounts are likely to be generous because the aim is to deplete the fund at a rate that will consume all the capital during the member’s lifetime.
The member retains control of the investment strategy within the fund, similar to a Sipp.
Hornbuckle Mitchell director Mary Stewart says: ‘The actuary will not be able to ignore gender as a significant factor when assessing the paying out of capital over a remaining lifetime. Under scheme pension, the idea is to take income at a pace which aims to maximise the money extracted during the client’s lifetime, which has the effect of minimising the amount of fund left at death.’
This contrasts with both annuities and capped drawdown where you can’t switch on higher income as health fades. Because in many cases more income can be taken via scheme pension, there is more scope for estate planning, using ‘gifts out of regular income’ rules. Also, the smaller residual fund left at death means there is potentially less left to face death taxes when the client dies and it is passed on.
The table below shows the maximum annual income an individual could take from USP/ASP, new capped drawdown, and scheme pension for different health situations. USP could have delivered more than scheme pension to someone in good health at age 65, but under capped drawdown, scheme pension delivers more at all ages shown.