When advising on retirement options, it is dangerous to jump to conclusions. In the vast majority of...
When advising on retirement options, it is dangerous to jump to conclusions. In the vast majority of cases, it would be wise for advisers to consider, admittedly in some cases briefly, all of the options conventional annuity, with-profits or unit linked annuities, income drawdown and the possibility of phased retirement. Clearly, phasing can be utilised in conjunction with any of the first three.
A conventional annuity has the merits of security and stability. It represents the only vehicle that provides a guaranteed income for as long as the annuitant (or annuitants) lives. Decisions are made and terms fixed on the date the annuity is purchased and cannot subsequently be changed. The provider will invest the annuity purchase price in long gilts and/or other fixed interest securities to match the guaranteed payments. This, of course, is why annuity rates have fallen so dramatically in recent years, reflecting the lower yields on gilts.
Income drawdown, on the other hand, gives flexibility in both the level of income to take each year and also in the investment strategy to follow post vesting. This is at the expense of some increase in risk there is no longer the guarantee of a specified level of income for life. At present, opting for drawdown does not replace the need to buy an annuity instead, it defers it to age 75 at latest. However, this also means the individual can defer deciding on the form of annuity to purchase. A 60-year-old married individual may find their spouse predeceases them prior to the later purchase of an annuity, making a joint life annuity inappropriate.
With-profits and unit linked annuities lie somewhere in between, but closer to conventional annuities. Rather than giving flexibility in the level of income, they give some increase in investment flexibility by avoiding the individual switching investment solely into fixed interest securities.
Matching the options
Some advisers may regard a conventional annuity as the default option. Many individuals retire with a relatively modest fund. They may have little other income, other than an increasingly inadequate state pension, and little other savings to fall back on. In such circumstances, a conventional annuity is the only option that will provide a secure, stable flow of income for life. Where the individual could not cope with a reduction in the income a conventional annuity would provide, then it is hard to justify any alternative.
Even here, the individual has choices to make. Should the annuity be level or escalating at 3% or in line with RPI? Should it have an attaching dependent's pension and if so, at what percentage of the own life pension? (Protected rights funds and post 6/4/97 occupational funds offer fewer choices). What about a guaranteed period? Rightly or wrongly, human nature leads many individuals to choose the option that gives the highest level of income in year one level, single life. The challenge to the adviser may be to highlight the potential pitfalls of such a choice.
For those retiring with larger funds, income drawdown becomes an increasingly valuable option. Individuals can have a wide variety of reasons for selecting drawdown. For some, the key benefit may be the flexibility it offers in income levels. Others may be attracted to the continued control over investment strategy. There is another group for whom health considerations are key. Yet others want to keep their options open - something which annuity purchase does not permit.
The band within which income can be selected is set once every three years, with the lower and upper limits being 35% and 100% respectively of a government actuary specified annuity rate. Such flexibility may appeal for a number of reasons. The individual may continue to have some reduced earnings in the years immediately following vesting and may wish to use the drawdown plan to supplement these. Some may not be able to predict the level of such earnings so again, the flexibility to amend the income with changing circumstances is valuable. One objective might be to keep income below the higher tax rate threshold.
Most drawdown providers will offer a wide range of funds to choose from. The investment strategy should be set to maximise the chances of the individual's objectives being met. In particular, it must be considered in conjunction with the level of income the individual wishes to draw. Where close to maximum income is selected, it would seldom be appropriate to invest in a safe fund which is unlikely to deliver the returns required to sustain maximum drawdown. Another objective might be to maintain annuity purchasing power, which may prompt a different investment strategy.
Historically, it has been best advice for drawdown plans to be documented as deferred self invested personal pensions (Sipps). The logic for this was that once drawdown had commenced, it was not allowed to transfer to a different provider, but by invoking the Sipp facility, it was possible to switch to a new fund manager - a 'get out' facility should the provider's investment performance disappoint.
Opting for a provider offering external fund links offers similar flexibility. The Inland Revenue has now indicated that transfers will shortly be allowed between personal pension drawdown plans even post vesting, scheme rules permitting. The principle is that income must then continue without any break, within the previously set limits.
Some commentators have suggested that this will kill off the need for deferred Sipp documentation but such claims are premature it may be considerably simpler and hence cheaper to simply switch to a new fund manager rather than to physically change drawdown provider. And as there is
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