Annuities and Income Drawdown

An annuity is an instrument for turning capital (e.g. a pension fund) into income. The person benefiting from the annuity is known as the "annuitant". The annuity rate determines how much income is produced by the fund. A guaranteed rate of 7.5% on a fund of £200,000 will generate an income of £15,000 p.a. before tax.

The Open Market Option

An annuity purchase is an irrevocable decision and the greatest care must be taken to secure the best rate from the most reputable providers. Personal pension schemes must now offer an Open Market Option which gives the prospective annuitant the right to buy the annuity from any annuity provider on the open market. The February 2003 Green Paper on pensions proposes to extend this right to members of money purchase occupational pension schemes.

Exercising the Open Market Option can make a significant difference to your retirement income, but it involves researching the market for the best rates from the most reputable providers. You can either approach an Independent Financial Adviser or research the market yourself using a service like the Hargreaves Lansdown Annuity Supermarket or William Burrows Annuities (WBA).

The Anatomy of an Annuity

The annuity rate is made up of two components:-

• An interest element based on the yield on long-term government securities.

• A "return-of-capital" element based on the life expectancy of the annuitant/s. The shorter your life expectancy, the higher the "return-of-capital" component and the overall annuity rate.

The annuity gives you a higher yield than is privately available through fixed deposits or fixed income securities. On the other hand, the annuity dies with the annuitants and the capital reverts immediately to the annuity provider (e.g. an insurance company) unless a guarantee is still in force at the time of death.

Compulsory Purchase (Pension) Annuities

Members money purchase pension schemes are obliged to buy Compulsory Purchase Annuities with the bulk of their funds before age 75.

The annuity will generally provide a guaranteed income to the annuitants for their whole of their lives with the following exceptions:-

• Where joint annuitants agree that only a proportion of the annuity (e.g. two-thirds, half) will be payable to the survivor on the first death

• Where an escalating annuity is chosen, and the income rises every year by some formula

• Where an investment annuity (with-profits or unit-linked) is chosen and the income may fluctuate in accordance with the underlying investments.

No capital is returned to the annuitants upon death, unless a guarantee is still in force at the time. Capital protected annuities deliver lower annuity rates than unprotected annuities.

What Kinds of Pension Annuities Are There?

Level The annuity rate is fixed for life at purchase.

Escalating The annuity income rises by a set factor each year (e.g. 3% p.a.). An escalating annuity generates a lower initial income than a level annuity. It may take several years before the escalating annuity generates a higher income than the level annuity

Investment Linked, notably "With Profits" and "Unit Linked", where the income payable may vary according to underlying investment performance

Guaranteed Where the annuity pays out for the balance of a given time period, even after the death of the annuitant/s (e.g. payable for at least 5 years from commencement)

Single Life An annuity written on one life only. A single life annuity normally terminates on the death of the annuitant unless it is purchased with a guarantee that is still in force at the time of death.

Joint Life & Last Survivor An annuity written on two lives (usually spouses) terminating on the second death unless a guarantee is still in force. A joint life annuity is more expensive than a single life annuity for any given ages, because the annuity provider expects to have to pay the income for a longer period of time.

Impaired Life A conventional annuity for those with a demonstrably shorter than normal life expectancy (due to illness, life style etc.), and therefore paying higher than normal rates

Flexible (offered by Prudential Assurance), allows the pension fund to be invested in a range of collective equity funds (rather than gilts) with an option to convert to a conventional annuity arrangement. Income levels can be changed within prescribed limits. Part of the fund can be ring-fenced to be returned on death within 10 years.

Open offered by London & Colonial and administered from Gibraltar, with investment freedom and recovery of the balance of the pension fund on the death of the annuitants through the purchase of shares in the insurance company.

Annuity Growth Account offered by Canada Life allows the pensioner to buy a 5-year temporary annuity to provide the same level of income as a conventional lifetime annuity, with the balance of the fund invested in growth funds. At the end of 5 years, the annuitant buys either another 5-year annuity (until 85 latest) or a lifetime annuity from the proceeds of the growth funds.

Flexible, open and annuity growth options should not be bought without taking advice they involve taking liberties with current pension rules.

Options for Drawing Pension Benefits

There are four options available:-

1. The member uses the whole fund to buy a Compulsory Pension Annuity

2. The member first draws off a tax-fee lump sum to the maximum percentage of the final fund permitted by Inland Revenue regulations. The balance of the fund is used to buy an a annuity. The pension will obviously be lower than in the case where the whole fund is used to buy the annuity

3. Defined Contribution Personal Pension plans (but not Retirement Annuities) allow the annuity purchase to be deferred until age 75. The member "draws down" income from the fund in the interim. Such an arrangement is known as "Income Drawdown".

4. Some individual pension plans can be split into numerous sub-plans (typically 1,000 or more). This allows the policyholder to draw benefits in phases. The policyholder draws a lump sum and buys an annuity with the proceeds of a portion of the sub-plans (e.g. 200), leaving the remaining sub-plans fully invested until benefits are required. This strategy is known as Phased Retirement.

The Great Annuity Debate

Improvements in life expectancy and falling interest rates have severely reduced annuity rates. Although interest rates are cyclical (and could rise again), increasing longevity is a long-term phenomenon and therefore an ongoing drag on annuity yields.

Not surprisingly, the retail financial services sector and potential annuitants are lobbying the Government to reform the rules for drawing benefits from money purchase pension funds. Among the solutions they offer is an extension of the income drawdown age limit beyond 75, enabling further deferral of the annuity purchase.

Other proposals by David Curry MP involve limiting the compulsory annuity purchase to that which would keep the pensioner off state benefits.

The Government and the Inland Revenue are both keen to see the present system retained, albeit with a few refinements. The Inland Revenue is determined that pension funds that have benefited from tax relief should be used to provide pension income rather than to shelter assets from tax and to facilitate tax-free transfers of capital to children under trust.

The Government argues that allowing people to defer annuity purchase almost indefinitely would remove the valuable benefit of mortality cross-subsidisation from smaller funds and ergo poorer pensioners. Under the present system, annuitants who die early subsidise those who live longer.

Among the refinements to the present system being considered are:-

Temporary annuities which would allow the annuity rate to be "renewed" at given intervals and at progressively higher rates.

Transferable annuities which would allow switches into, say, impaired life annuities.

Capital Protected (Money Back) Annuities with lower initial rates but with reversion of all or part of the capital to heirs on death, less income tax.

To a large extent, however, the annuity debate is a sideshow. Increasing longevity means that our capital has to stretch further, no matter how we hold it. The problem goes wider than pension funds.

June 2003