Once the Government has confirmed its intentions, there are likely to be more players entering the investment-linked and flexible annuity market to create a more competitive environment
The Government's controversial proposals for annuity reform are unlikely to add any genuine choices to the market. Arguably, however, the problem with the current rules is not a lack of choice but the price investors are prepared to pay to retain flexibility and control.
Once the Government has confirmed its intentions, we will hopefully see more players enter the investment linked and flexible annuity market to create a more competitive environment.
At present, for the sophisticated investor with a substantial pension fund, the combination of phased retirement or phased drawdown and a flexible annuity purchased at age 75 provides a dynamic retirement and inheritance planning vehicle.
For the client who enters a phased or drawdown arrangement but who has become more risk averse by age 75 or for whom income, rather than death benefits, is now the priority, a conventional index-linked annuity with a 10-year guarantee might prove the most satisfactory post-drawdown route.
Ironically, short-term annuities ' one solution put forward by the Government to meet the changing needs of investors in retirement ' could be a far riskier alternative than anything currently available. Such a product would not provide the insurance against longevity that is offered by conventional annuities. Nor would it confer inheritance planning flexibility and investment freedom on the annuitant.
Phased retirement, by contrast, allows the investor to build up a portfolio of annuities over a period of up to 25 years and retain considerable flexibility over the death benefits of the remaining unvested fund.
This structure avoids the risk of committing the whole of the pension fund to an annuity when investment conditions may be unfavourable. By phasing the purchases, the investor effectively drip-feeds the equity-based pension fund into the bond-based annuity market.
Billy Burrows, of William Burrows Annuities, is a keen advocate of phasing. 'It is practically impossible to predict the right time to buy an annuity,' he says, 'just as it is impossible to guarantee investment returns. In the long run, phasing should help to reduce these risks ' pound-cost averaging in reverse, if you like.'
When weighing up the differences between phased retirement and drawdown investors should understand the potential downside of remaining outside of an annuity framework. Through an annuity, the mortality cross-subsidy might add anything from 1% to the client's annual income at age 60, to 7% at age 75, irrespective of the type of fund in which the client invests.
It is clearly important that clients consider their options in the light of their fund size, attitude to risk and inheritance planning requirements. While phased retirement is likely to be the most effective way to buy a series of annuities, it does require the client to use the tax-free cash available on vested segments as part of the annual income. Advisers keen to employ phasing may be able to overcome client resistance to this idea if a separate investment is built up alongside the pension fund and used at retirement to fund capital projects. This would be an ideal role for the individual savings account portfolio.
So how does phasing work? Under phased retirement the personal pension fund is divided into segments ' typically 1,000. Each year the client withdraws the number of segments required to provide the target income, which is achieved through a combination of the tax-free cash available on each segment (usually 25%) and the purchase of a conventional or investment-linked annuity to provide a taxable lifetime income. The unvested segments can be written in trust for the beneficiaries who would receive the fund as tax-free cash. The beneficiaries would also receive the income from any guarantees or spouse's pension secured on the annuities already purchased.
The popularity of income drawdown is largely because of the availability of the tax-free cash at retirement.
In taking the full amount, however, the client automatically vests all the personal pension plan segments. If the beneficiaries wish to take the fund as a lump sum on the annuitant's death, this would be subject to a 35% tax charge. During the drawdown period, the income level is flexible, although it must fall between a minimum and maximum set by the providers based broadly on the annuity rate the client would otherwise have secured with the fund at retirement.
For clients whose priority is death benefits but who nevertheless require an income, phased drawdown may offer the optimum combination. Here, the client draws the income from the fund directly but makes use of the tax-free cash in the same way as for phased retirement. As there is no annuity purchase, the client effectively increases the death benefits but at the expense of the guaranteed income from the annuities.
Despite the complexity of the phased or drawdown arrangement, the success of this arrangement will depend less on tax expertise than on good asset management. Danny Cox, pensions manager at adviser Hargreaves Lansdown, stresses the importance of portfolio construction and the use of a discretionary trust to enhance death benefits.
He says: 'A good starting point for a portfolio could be to use a standard model, such as the Association of Private Client and Investment Managers' (APCIMS) balanced portfolio. Clearly, the client's individual needs and risk tolerance must be taken into consideration and this may result in a slightly different asset allocation.'
The asset allocation, following the APCIMS model, might be as follows or could substitute a property portfolio for part of the overseas equities allocation. For example:
UK equities 55%
International equities 20%
Where the tax-free cash is taken at retirement, Cox advocates the careful use of a discretionary trust to optimise death benefits and minimise inheritance tax. Rather than pass on the fund directly to the spouse, the death benefits could be nominated to a discretionary trust, with the spouse and children as potential beneficiaries and with a loan facility for the spouse.
By age 75 at the latest, the client must use any remaining fund to buy an annuity and it is unwise to leave this until the last minute.
Where the client intends to move into a conventional annuity then the asset allocation should be reviewed to bring the fund in line with the bond market.
However, as mentioned above, the client has the opportunity of converting to an investment-linked annuity, which offers the benefit of the mortality cross subsidy, or of safeguarding a high proportion of the fund as a death benefit by using a product like the Prudential Flexible Lifetime Annuity. Where the death benefit is the absolute priority then the London & Colonial annuity might be worth the additional cost.
The problem with the annuity market is not lack of choice but how much investors are prepared to pay to retain flexibility and control.
Once government policy is determined we should see more competition in the investment-linked and flexible annuity market.
For the wealthy investor the optimum retirement solution might be phased drawdown followed by the purchase of a flexible annuity at age 75.
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