In light of recent changes, the Government needs to consider the implications of moving from a pension system based on insurance and cross-subsidy to one based on individual investment returns
Like nature, financial institutions and advisers abhor a vacuum and are ever eager to fill a perceived gap in the lucrative pensions market. Enter the Open Annuity from London & Colonial, marketed in the UK through Australian insurer and annuity specialist Challenger. The Open Annuity appears to be a legal bombshell designed to bypass the field of landmines that has hitherto defended the Inland Revenue rules on the vesting of defined contribution pension funds.
In practice, the element that is authorised in the UK is little different from drawdown. The fund return on death is achieved through a Gibraltar structure that hands over to the estate of the policyholder the equivalent of the outstanding fund. This is why policyholders have to purchase a preference share in the insurer for £1,000 at the outset. It is a complex, cunning and expensive weapon that should appeal only to the very wealthy who want to use their pension fund for inheritance purposes rather than as a source of income.
For this group, the way forward is probably to leave their pension fund where it is ' and this would probably be a self invested personal pension ' until age 75, at which point, if nothing better has been launched, to move into the open annuity. An alternative is the Prudential flexible annuity, but here the maximum of 80% of the fund that can be ring-fenced for inheritance purposes is only secured until age 85 at the latest.
A 75-year-old man can expect on average to live a further 11 years and a woman 14 years. Given the fact that the wealthy tend to live longer than average, the Prudential product may not meet their inheritance planning requirements.
The open annuity is nothing to do with the pooling of mortality risk and the provision of a lifetime income ' but everything to do with inheritance planning. Whatever value is left in your fund on death will be payable to your estate. As competitors unpick the mechanism and launch their own versions, the costs ' 3.75% up front and 1.5% per year, plus investment charges ' should tumble and the market expand.
As we await the Government's consultation on annuities, expected later this month, it is timely to consider how best to serve the interests of the very wealthy minority and yet preserve the financial security of the majority. The lawyers can take the insurance out of the annuity but they cannot take the panic out of the pensioner.
There are several issues here that the institutions and advisers, the Government and regulators might all consider in the wider debate. First, how can we prevent what is clearly intended to be a niche product from falling into the wrong hands?
In this respect it is helpful to consider the recent past. The arguments against conventional annuities are very similar to those we heard in the late 1980s against final salary company pension schemes. Arguably, if compulsory annuities were abolished, we could end up with a mis-selling scandal on a similar if not greater scale to when insurance company representatives and independent advisers persuaded employees with guaranteed company pensions to 'unlock' their funds and set them free by transferring to equity-based personal pensions.
The cynical public might also wonder why it is that some of the culprits at the heart of the mis-selling scandal are behind the 'innovative' annuities. Prudential is a name that stirs up feelings of admiration and fear in equal measure. Admiration for its innovative research and fear of its influence in the mass market.
This is not an exercise in name bashing. Experience indicates that where rules are relaxed in order to benefit a minority group ' in the annuity debate this is investors with a disproportionate amount of capital tied up in their pension fund ' the financial institutions tend to promote the new arrangement to the mass market. The stakes are high: about £6bn was transferred from matured pension schemes and plans into annuities last year. From the point of view of those advising and managing client assets, there is more to be made in annual fees from a pension fund portfolio than from annuity purchase, just as there is more to be made from recommending an insurance bond over an investment trust.
Second, given the length of retirement and the increasingly complicated financial requirements of these years, it is perhaps time to question whether institutions and advisers should automatically recommend that clients concentrate investments in a tax-efficient but restrictive pension arrangement. The financial advisers and institutions that are now keen to see annuity rules relaxed are also largely responsible for encouraging clients to maximise pension contributions in the run up to retirement. You only have to read the consumer and professional press to see that for every balanced comment on diversification of retirement income sources, there are ten features on maximising pension contributions.
Good advice in future might focus on building up a range of different sources of capital and income for the retirement years. It might also be appropriate in certain cases to encourage later retirement or a period of semi-retirement during which only a small pension income is drawn supplemented by an earned income. One wonders whether this type of advice can be provided on anything other than a fee basis.
The third issue that the Government in particular should address is the long-term role of insurance in the private pensions sector. Many actuaries believe that it is impossible to reconcile the desire to avoid the annuity route with the financial and arithmetic risk of running down capital in late retirement that could leave those blessed with an above average life span with little or no income. The insurance element of annuities allows investors to squeeze extra income out of assets over a lifetime, no matter how long they live or what happens to investment returns. It is the only product that achieves this objective.
Looking at the bigger picture, the Government should consider the implications of moving from a system of pensions that incorporates a strong element of insurance and a cross subsidy between different generations of workers ('pay-as-you-go') to one based wholly on individual investment returns. In this context, we should note the significant shift from defined benefit company schemes to defined contribution.
Over the past year (to end October), the National Association of Pension Funds (NAPF) reports a sharp increase in the closure of DB schemes to new members. At 46, this is more than double the closure of the previous 12 months.
DB schemes can be regarded as a combination of pay-as-you-go and self-insurance through the pension fund. As far as the member is concerned, there is no link between the contributions paid and the benefits secured. Full death benefits apply usually from day one and the rate of pension is guaranteed irrespective of the member's lifespan or of investment returns.
A similar shift in risk is apparent in the state pension. From next April, the Government closes the defined benefit scheme (Serps) to new members and will use a carrot and stick campaign to shift all but the very low earners into DC stakeholder schemes as a substitute. Experience from other countries demonstrates that no one pension system has been proven to work well throughout economic cycles and cope with shifts in demographic and employment patterns. A balance of insurance, pay-as-you-go and investment may be the most prudent way forward.
The arguments against conventional annuities are similar to those heard in the late 1980s against final salary company pension schemes.
Around £6bn was transferred from matured pension schemes into annuities last year.
Over the past year there has been a sharp increase in the closure of DB schemes to new members.
The increase in minimum AE contributions has had little impact on opt-out rates - with cessations after April increasing by less than two percentage points, data from The Pensions Regulator (TPR) shows.
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