Yes, you read the heading right. We are all aware of the arguments around pension annuitisation. Whether it is a good idea? When to buy an annuity? How much of a client’s pension savings should be used to buy an annuity?
The biggest asset most retirees have is their house – often a lot more than their pension savings. No wonder more than 20% of those over 50 intend to use their housing equity to augment their pension savings. Many will look to withdraw their equity by moving to a house that costs less to buy than the value of their current home. This will provide them with a capital sum.
To turn this capital sum into retirement income means drawing it down, in much the same way as pension drawdown. However, it is a little more complicated than that. The capital sum realised will be liable for income tax on the savings and dividend incomes produced, and CGT if the annual allowance is exceeded. The drawdown strategy should attempt to minimise these taxes.
It may be possible to manage the capital sum without paying tax but the larger the sum, the more important it may become to make use of ISA and pension allowances to get it into a tax-advantaged environment. The latter may not be available to someone over age 75, may be restricted to £3,600 a year if no employment income exists, or £4k a year if it does, but the pension savings have already been flexibly accessed.
The amount of sustainable income that may be drawn will depend to some extent upon how the capital sum is invested but should be subject to regular review. Here a stochastic cash flow planning tool may be useful.
Some people are risk adverse and would like, or need, to convert their capital sum into a guaranteed income for life. Here the often-forgotten purchase life annuity could have a use. The purchase life annuity market is restricted and enhanced terms for those with health issues are not available. They should only be considered by healthy clients.
To obtain the capital sum, sizeable transaction costs will be incurred in selling and buying a new house. In addition, there are the costs of moving, possibly redecorating and refurnishing. Also, many older people do not want to move from where they currently live. However, equivalent solutions would be available through the equity release market.
Drawing a lump sum through equity release and using the proceeds to purchase a purchase life annuity could be used, if there are no children or other dependants that the estate could be passed to.
I am more cautious about using equity release to create a capital sum from which regular income will be drawn, particularly if there are dependants involved. In these circumstances an equity release drawdown account will preserve a greater inheritance.
Up until now equity release drawdown has meant being provided with a facility from which withdrawals can be taken – each withdrawal being subject to a significant minimum. Now Legal & General have introduced a monthly drawdown facility – however this is restricted to income over a fixed term between 10 and 25 years that is selected at the outset.
This is very similar to using the house as a temporary annuity. At older ages with longer terms this becomes close to providing an annuity. Some 90% of clients aged 75 that select a 25-year term will not be alive at the end of that term. At older ages, if pension and other savings have been depleted, will products such as this be used to provide income for the remainder of expected life?
There is a sting in the tail. It is believed there are 170 people alive in the UK over age 107, the eldest being 113. These numbers should be expected to increase over the next 25 years. What is ‘plan B’ if your client lives to age 110?
I am sure that other providers will soon follow Legal & General and introduce similar monthly income products. Will they be able to differentiate by offering longer terms or even offer a lifetime contract at older ages? A move in this direction, which may not be a great step to take, and we could enter the territory of equity release enabling the home to be used as an annuity. This could become a popular proposition with the public.
What would this mean for later life planning? One solution that could be considered, now the Legal & General product has been introduced, would be to use pension savings to fund retirement up to age 75 or older, leaving a reserve of say 10% of the initial pension savings. From that age the equity release via a monthly income drawdown plan could be used. If the client dies before the expiry of the monthly income drawdown contract, the pension savings could be passed on as an inheritance. If the client outlives the drawdown contract, the pension savings could be used to provide income for the remainder of life.
Product innovation creates new planning opportunities. To advise on those opportunities may require new knowledge and skills. The later life market is developing fast. Are you keeping up with developments?
Bob Champion is chairman of the Later Life Academy