August 2008

Taking a different view

In the increasingly competitive world of work, today's employer is under greater pressure to ensure the benefits they provide contribute directly to influencing employee behaviour, generate a maximum return on investment and help win the war for talent.

A recent survey in the press found that 97% of the 250 advisers polled were in favour of abolishing the age limit at which a compulsory annuity should be purchased. The main justifications for this were cited as 'inability to remain invested', 'to allow continued contribution if clients are working', 'to enable financial assistance for children/grandchildren'.

The effect on the pensions market of abolishing compulsory annuitisation should not be underestimated. We are used to hearing arguments such as these for abolishing compulsory annuitisation but they mostly ignore the alternatives and the downsides.

Product providers with accumulation products campaign for abolition of age 75. Some annuity providers campaign for keeping age 75. Lawyers want industry support to argue the alleged 'breach of human rights'. IFAs campaign for their client who doesn't want to have to take income and surrender the control they have within their SIPP. Investment managers campaign for their clients who can no longer benefit from investment advice post 75. However, what would be the implications for the majority of individuals with the average pension pot who rely on the guarantee of income that conventional annuities provide? These individuals probably cannot afford to pay fees to an IFA and probably won't be looking for investment advice.

The current average purchase price of an annuity is under £30,000. For the majority of individuals with the average pension pot the product of choice will be the conventional annuity. The consequence of taking away the compulsion for annuitisation is that all annuities will inevitably become voluntary. It is generally accepted that if pension annuities were to become voluntary then ultimately the cost will rise. One danger could therefore be that those individuals with average pension pots who need the guarantees of a conventional annuity will have no choice but to suffer a hit on their income.

'Mortality drag' will for the majority of people with average pension pots make the cost of delaying annuity purchase unfeasible. In order to beat mortality drag an active investment strategy will need to be adopted which will come at a cost. In addition to the financial cost there is an increased investment risk that they will probably not be willing to take.

Returning to the arguments in favour of removing the age 75 threshold ... Some individuals do not need income at 75 and/or would prefer to continue to invest their own pension funds rather than be forced to purchase an annuity. In addition they cannot continue to make pension contributions and obtain tax relief. The real challenge would be for innovative product development to work within the existing compulsion for annuitisation without compromising on flexibility or choice.

Changes in legislation effectively already allow individuals to continue to make pension contributions post 75 albeit on behalf of others aged under 75. Perhaps these could be to pension schemes for other family members or business partners. Assuming for example contributions are made on behalf of grandchildren then the grandchildren will be able to obtain tax relief at their highest marginal rate. The donor will then benefit from the same sum being outside of their estate and potentially save IHT.

Flexible options

Another argument put forward is that the timing of 'cashing in' accumulated funds to start decumulating at age 75 could be inappropriate should the market conditions at the time be unfavourable. However, some flexible annuity providers permit clients to 'transfer in specie' their accumulated pension pot. Flexible annuities are lifetime annuities that allow open architecture investment but within the post annuitisation environment. Some of the flexible annuities that have been recently developed are beginning to look more and more like SIPPs allowing whole of market investment choice. In addition some also continue to offer the annuitant the option to switch to a conventional annuity provider at any time - which was not previously allowable under pre A-Day legislation.

Flexible lifetime annuities allow the annuitant to continue to gain exposure to the markets and invest their own pot of money in a similar way that they can within a SIPP. Some products are able to accept 'transfers in specie' of permitted investments which eliminates any risk in being out of the market while exercising the OMO.

Some financial advisers have acknowledged that using a combination of financial products can produce powerful results. One such combination is to use a flexible annuity in conjunction with an investment bond. Individuals who purchase a flexible annuity will be able to choose their own level of income between 50% and 120% of the conventional rate. In this context post 75 a flexible annuity allows 120% of the conventional rate compared with ASP which is only 90% of the GAD rate. The maximum income is then stripped out of the fund with the majority of the income being placed into an insurance bond held under trust for the next generation. Any income taken which is surplus to requirements could be contributed to other pension schemes as described above.

The perceived age 75 barrier therefore needs to be put into perspective. There is no compulsion for people to give up work at age 75. Individuals can continue to make pension contributions past age 75 (albeit only on behalf of others); they can continue to vary their income levels and continue to have exposure to the markets by controlling their investments.

Of more concern is the fact that (according to FSA figures) currently only some 35% of individuals actually exercise their open market option (OMO). Use of the OMO has already had plenty of coverage however the perception among some advisers seems to be that the definition of a lifetime annuity is that once the decision has been made the client is somehow tied in for life. When I explain to some advisers that some lifetime annuity providers continue to offer the OMO even after annuitistation the normal reply is "How can that be a lifetime annuity then?" All the propositions allowed within the current post 75 environment need to be fully appreciated before arguments for abolishing compulsory annuitisation can be taken seriously.

The 'at-retirement' options available post 75 are limited only to the extent of innovative product design and holistic financial advice. As the legislative framework already exists to allow lifetime annuities to be developed to look more like SIPPs perhaps 'compulsory annuitisation' could be renamed 'compulsory review'.

Adam Wrench
Product Development Manager
London & Colonial