The wide range of pension options now available are increasingly complex making choosing the right scheme something of an exacting science
Retirement is no longer the simple decision it once was. The State Pension Age is being reviewed and will probably be increased, we are continuing to live longer and current economic conditions are difficult.
The range of pension options available is also more complex and quite often a mix of the options available might provide the optimum solution.
The advice process for retirement is also becoming multifaceted and there are a number of factors that need to be considered, including attitude to risk, age, health and benefit provision for the family.
In this respect, it is important to have a robust process for retirement planning to ensure that all angles are covered.
Annuity purchase
Up until 1995, annuity purchase was the only real opportunity of converting a pension fund into an income stream.
Increasing longevity and falling interest rates have meant that annuity rates have steadily fallen and the general feeling is that they are uncompetitive.
They do however provide absolute security and the level of income bought will be paid for life. Towards the end of 2008, annuity prices did look more competitive than they have for a long time but during 2009 they have started to fall once again.
Most annuities sold are level annuities with no inflation proofing to gain the highest starting level. This might not be a problem at the moment with the headline rate of inflation falling, but could mean loss of value over a long life.
Unsecured pension (USP)
Until A-Day in 2006, this option was known more commonly as income drawdown, which was introduced in 1995, allowing an income to be taken from a pension fund leaving the rest invested. Some of the key issues that come into play in the current climate are the fact that:
- there is no need to take an income each year;
- a member can, subject to the rules of the scheme concerned, vary the amounts taken each year within the specified limits;
- the maximum income must be reviewed every five years or more frequently at the direction of the member and consent of the administrator;
- there is a lump sum death benefit available among other options.
While not having the certainty of an annuity, the key elements of USP have been flexibility of income and the availability of a death benefit.
But it is vitally important to remember that USP is primarily an investment contract in so much as the funds that remain invested need to produce returns for the future and in current markets this could be difficult.
In some ways the USP market has polarised - at one end of the spectrum is the traditional USP client, perhaps with a fund in excess of £300,000, other wealth available and who is prepared to dip in and out for income as and when required for ad hoc income payments.
At the other end we are now seeing USP much more commonly used by people with funds of less than £200,000, who have got few other assets and need the maximum they can in terms of income. This type of client does not want the inflexibility of an annuity, which would probably suit them best, but they cannot afford to lose money. In such cases, I think that the investment problem is very different and maintaining purchasing power whilst aiming to keep the original capital is the order of the day.
With it harder to find investment performance it should mean that fewer people choose USP. Income drawdown does not work itself – there needs to be some correlation between the level of income needed and the critical yield with the investments that are being used. If individuals are not prepared to take the requisite level of risk, then perhaps the advice should be for them to buy an annuity.
Many USP clients will have suffered a real ‘double whammy’ in that their fund value will have fallen quite dramatically at the same time as the necessary Government Actuary Department (GAD) rates. The conundrum for such clients, particularly if they have a review date coming, is when to lock in for another five years. Should they take a view on equity performance improving or gilt rates improving?
Alternatively secured pension (ASP)
ASP in effect is a continuation of drawdown past the age of 75 and therefore much of what has been said about USP applies. ASP loses much attraction because of the possibility of an 82% tax charge on any remaining fund on death.
The final option is that of a scheme pension which, post A-Day, can be paid from any type of pension arrangement. In effect the scheme ring fences an individual’s pension fund and an actuary calculates the pension according to the age and health of that individual. The actuarial assumptions are therefore important and any fund used to produce scheme pension is likely to be reviewed every three years. If the fund cannot sustain the level of scheme pension then it is likely to be reviewed in the future.
These are the main retirement options available, but there are also some new ones such as ‘third way’ products and temporary annuities.
Any successful process needs to look at flexibility versus security, the ability to pay death benefits versus income, and needs to have a thorough understanding of investment markets and the correlation of different asset classes.
In an increasingly regulated world, a prescribed process will assist in documenting a specific client’s needs and will also help to demonstrate a culture of treating customers fairly.
Mike Morrison, head of pensions development, AXA Winterthur Wealth Management
