It’s wise to seek expert advice when considering annuities, says Bestinvest15 April 2013
While the first quarter of 2013 has seen annuity rates improving for the first time in two years, rates continue to be low, far below historical highs seen in the 1990s. David Smith, Wealth Management Director at Bestinvest looks at the reasons behind this current situation and the options available for those looking to maximise the impact of their annuity.
“In 1990, the UK Base Rate hit 15%, inflation soared to 10.9% and there was relatively low demand for gilts. This combination of factors resulted in very high annuity rates; a 65 year male, buying a single life, level, non-guaranteed annuity with a £100,000 fund in 1990 could have secured an annuity rate of over 15.5% – equating to an income of £15,500 per annum.
“Today, the UK Base Rate is 0.5%, Consumer Price Inflation is 2.8% and demand for gilts has soared, resulting in historically low yields. Consequently, annuity rates have fallen to the point where a 65 year old man buying the aforementioned annuity today could obtain a rate of just over 5% and receive an income of just £5,000 from the same £100,000 pension fund.
“Annuity rates have been negatively affected by normal life expectancy improving; the longer we live, the longer insurance companies have to pay pensions and therefore the lower annuity rates become. Equally more stringent European legislation and solvency requirements for annuity providers and the equalisation of annuity rates for males and females have all had an impact. With annuity rates likely to remain low for some time yet, it is very important to shop around for the best deal.
“However to make matters more complicated, comparing market rates for the best deal is no longer enough. There are numerous alternatives to conventional annuities such as Flexible Income, Income Drawdown, Investment-linked annuities and ‘third-way’ annuities, all of which need to be considered. Using the ‘Flexible Income’ facility for example, it is possible to draw an uncapped
pension income, or indeed the full value of your fund as a lump sum. However you would typically need a fund of £500,000 plus to access this option and would need to be aware of the associated tax issues.
“With so many options available, expert advice should always be sought to ensure you make the right decision – one that will need to take you through your retirement.”
In the following Appendix, Bestinvest’s David Smith examines the main differences and suitability for each of the annuity options described in this press release.
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Founded in 1986, Bestinvest was a pioneer of helping clients reduce the costs of investing through discounting commissions. Today Bestinvest has grown into a leading private client adviser which helps over 50,000 investors. Bestinvest offers a range of services including guidance, investment advice, financial planning and discretionary portfolio management all of which are underpinned by a commitment to rigorous investment research. Through its low cost Select service, Bestinvest offers execution-only investors a Self-Invested Personal Pension Plan (SIPP), Individual Savings Account (ISA), Junior ISA (JISA) and Investment Account with access to more than 2,000 funds as well as investment trusts, shares and Exchange Traded Funds. Bestinvest has won numerous awards including ‘Self-Select ISA Provider of the Year 2011’ and ‘UK Wealth Manager of the Year 2011’ as voted by readers of the Investors Chronicle and Financial Times and Investment Adviser of the Year 2012 at the Professional Adviser Awards. Headquartered in Mayfair, London, Bestinvest has 14 regional offices with 200 staff servicing clients with over £4 billion of assets.
Appendix - Annuity options
Fixed Term Annuities
Fixed Term Annuities (FTAs) provide a ‘guaranteed’* income for a fixed period; say three, five, ten or fifteen years, which can be up to 20% higher than you could generate from a conventional, comparative annuity. As there is no minimum level of income that must be taken you could even take the full Pension Commencement Lump Sum (PCLS) and no income initially.
* the income you can take from a Fixed Term Annuity is subject to limits set by Her Majesty's Revenue & Customs (HMRC) in conjunction with the Government Actuary's Department (GAD). These income limits will be applied every three years and if the income provided by the FTA is higher it will have to be reduced in line with HMRC limits. With some contracts, any income that cannot be paid because of the limit will be added to the maturity value of your plan to increase the GMA, thereby ensuring that its value is not lost.
At the end of the income period you will be paid a guaranteed maturity amount (GMA). This GMA will vary depending upon the product, amount of income withdrawn and length of the initial fixed period. This pay-out can then be used to purchase a further Fixed Term Annuity, a conventional annuity or moved into any of the other options explained.
Various death benefits can be incorporated including:
- Spouses Pension: This can be at the full rate the policyholder was receiving or at a reduced level (i.e. two thirds or a half). However, this continuing income is only payable for the remainder of the fixed term, with the GMA then being available for reinvestment by the surviving spouse at the same selected percentage level of the income. For example, if you select a 50% Spouse’s Pension then they would receive 50% of the GMA.
- A Guaranteed Period - this ensures that the income will be paid for a minimum number of years from the start of the contract (typically five or ten years) or your lifetime if greater.
- Value protection - if you die before all income payments are at least equal to the original purchase price, the difference will be returned less a 55% tax charge (if the money is reinvested in another pension income product, instead of taking the lump sum, the tax charge does not apply).
The more death benefits incorporated, the lower the maximum starting level of pension. A Fixed Term Annuity may be suitable for an individual who expects annuity rates to rise in the future and wants a guaranteed income, albeit only for the initial term selected. The importance of providing a significant lump sum death benefit for spouse and/or children would be of secondary importance, as would having income flexibility other than at the start of each fixed income period. FTAs are generally available for those with pension funds worth £20,000 or more. Anyone considering purchasing an FTA must be willing to accept that their income could fall at the end of the fixed income period.
Advice costs would need to be incurred at inception and at each income review period. Any income generated would be subject to income tax.
Investment Linked Annuities
Any PCLS is typically taken in full at inception, but can be taken in part.
With an investment-linked annuity your pension income varies each year to reflect changes in the value of the underlying investment, typically: With-profits - Your income is linked to the performance of the annuity provider’s with-profits fund. With Profits Annuities offer a smoothed level of investment returns and therefore a structure to limit the downside of the contract. Unit-linked - Your income is invested in conventional, non-smoothed, funds and returns are directly linked to the performance of these funds. As such they are typically higher in risk than their With Profit counterparts.
To establish what the starting level of income will be, an assumption has to be made in terms of what future investment returns are likely to be. If a high rate of return is assumed of say 6% then your starting income is likely to be significantly higher than that available through a conventional annuity. In contrast, if a low rate of growth is assumed of say 1% then your starting income is likely to be lower: The higher the level of assumed investment growth, the greater the risk that your future income may fall and vice versa (NB - most investment-linked annuities limit this risk by providing a guaranteed minimum income level which cannot be breached regardless of underlying investment performance).
The same death benefits mentioned for Fixed Term Annuities can be incorporated within Investment Linked Annuities.
An Investment Annuity may be suitable for an individual who expects annuity rates to rise in the future and/or is willing to see their income rise or fall each year but isn’t willing to take the risks associated with Uncapped Income Drawdown or may have too small a fund to access Uncapped Income Drawdown. Investment Annuities are also suitable for those who want the flexibility to be able vary their income periodically, perhaps to mitigate income tax. The importance of providing a significant lump sum death benefit for spouse and/or children would be of secondary importance. Investment Annuities are generally available for those with pension funds worth £20,000 or more.
Advice costs would need to be incurred at inception and advice would also probably be required at each policy anniversary.
Any income generated would be subject to income tax.
Any PCLS is typically taken at inception, although through the use of Phased Capped Drawdown the PCLS can be taken in tranches, which can provide valuable tax planning opportunities.
The maximum allowable income available is calculated by the pension provider using tables provided by the Government Actuary's Department (GAD). This initial maximum income limit remains in place for three years and is recalculated every three years thereafter (from age 75 onwards reviews take place each year). The maximum income limit is currently circa 20% higher than you could generate from a conventional single life annuity. The minimum limit is currently zero.
With Capped Drawdown pension funds remain invested and income is withdrawn direct from the fund. As a result, future income is not guaranteed and will fluctuate. If the pension funds perform poorly and too much income is withdrawn, the Capped Drawdown income could reduce or even cease over time (if the pension funds are entirely depleted).
On death there are three options available to the beneficiary; they can take the remaining fund value less tax at 55%, they can use the whole fund value to buy an annuity for themselves or they can continue with the Drawdown arrangement.
Capped Drawdown may be suitable for an individual who expects annuity rates to rise in the future and is able to accept that their income will rise or fall significantly at each review. As income can be amended (subject to aforementioned minima and maxima) each year it is also suitable for those individuals that want to have full control over their taxable income, perhaps in order to avoid paying higher rates of income tax. Capped Drawdown is also frequently preferred by those individuals who view leaving a lump sum to their spouse and/or children a priority and/or do not want to make a definitive decision in terms of how to provide death benefits. Typically you need a pension fund of at least £100,000, but arguably £250,000, to make this a viable option. For small pension pots the costs can be very high.
Advice costs would need to be incurred at inception and advice would also probably be required at each policy anniversary. Any income generated would be subject to income tax.
Uncapped (Flexible) Drawdown
Flexible drawdown in its basic form is very simple; it is the option to take unlimited withdrawals from a pension from age 55 but to qualify you must have a guaranteed pension income of £20,000, the "Minimum Income Requirement". As the pension fund remains invested it will rise and fall in line with the performance of the underlying funds in which it is invested.
This minimum income requirement must be generated from a pension where the income is guaranteed not to fall (i.e. State Pension, conventional annuity, Defined Benefit Pension income etc.) and the pension must be in payment. As a result other drawdown income cannot be taken into account, nor can any income generated from investment linked annuities (except for any guaranteed element). Once in flexible drawdown you cannot contribute to a pension or be an active member of a final salary scheme.
Uncapped Drawdown may be suitable for an individual who wants full control over when and how much income he is able to draw from his pension, perhaps in order to avoid paying higher rates of income tax. Uncapped Drawdown is also frequently preferred by those individuals who view leaving a lump sum to their spouse and/or children a priority and/or do not want to make a definitive decision in terms of how to provide death benefits. Typically you need a pension fund of at least £100,000, but arguably £250,000. For small pension pots the costs can be very high.
Although the PCLS can be taken in full at inception, it is often taken in part or not all. This is because taking no PCLS at inception can provide valuable tax planning opportunities in that 25% of every withdrawal can then be taken tax free with only 75% being subject to income tax. Of more import the non-vested proportion of the pension would be payable tax-free on death prior to age 75 offering significant inheritance tax savings. Any vested monies remaining in the pension would be subject to the same death benefit options as under Capped Income Drawdown.
Advice costs would need to be incurred at inception and advice would also probably be required at each policy anniversary.
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