There are few issues in the pensions world that unite as many people as the need to abolish the comp...
There are few issues in the pensions world that unite as many people as the need to abolish the compulsion to buy an annuity at age 75.
But before looking at this subject in detail, it is worth making a couple of points. For the vast majority of people, annuity purchase will be the right option, security of income is the main factor. However, for those for whom income drawdown is a suitable product, why should it have to cease at age 75? Surely choice is essential?
Up until 1995, people were required to buy an annuity from all personal and most occupational pension schemes.
But falling annuity rates have turned the emphasis on to the amount of income that could be purchased from a hard-earned pension fund. This focus has been sharpened by the move towards money purchase pension provision rather than the guaranteed amounts promised by defined benefit schemes.
The result of this combination of factors was the introduction of income drawdown. No longer did an annuity have to be purchased between the ages of 50 and 75, but an income could be drawn from the pension fund within specified limits.
This was a radical change at the time but, over the years, we have all come to know and love the rules for income drawdown. The problem has always been the requirement to buy an annuity at 75.
It is now clear that income drawdown has been attractive in a number of situations:
l Those individuals with a pension fund large enough to leave it invested in investment markets in equities other than gilts.
l Those that require some income from their pension fund but not the maximum.
l Those with other assets that mean the pension fund is not their only source of income.
l Those individuals wishing to retain some control over their pension fund capital perhaps with a view to passing some of it on.
As with many areas of financial planning, individual circumstances do dictate every case but some general assumptions are appropriate. First, income drawdown is likely to work best if investment is in equities. If maximum drawdown is required, an annuity may be a serious consideration.
Finally, a fund of at least £250,000 to £300,000 is usually needed for income drawdown although, as mentioned above, individual circumstances will dictate the situation.
Income drawdown is not without risk. Obviously having the pension fund invested in the market means exposure to capital risk and the possibility that investment returns will not be as anticipated. Annuity purchasing power may also fall as a result.
Add to this the lack of mortality cross-subsidy interest in the purchase of an annuity (mortality drag) and the conversion risk of possibly having to buy a fixed price annuity, then income drawdown can be a risky alternative.
But despite these risks, surely individuals should be able to choose how they invest their pension funds?
There appears to be a growing acceptance that income drawdown should be treated as an investment product rather than a pension product. An individual client will discuss his income requirements from the pension fund with his adviser, and the fund will then be invested with the aim of producing this income amount. In many drawdowns, the need to compare with a conventional annuity may be superfluous if the individual has no intention of ever buying an annuity.
For many cases, a rigorous set of procedures and professional advice will mean a facility that benefits all. However, there are always likely to be a few cases where individuals are not advised appropriately and where a pension fund is jeopardised.
It is with this in mind that we should welcome instructions from the Financial Services Authority that it plans to make advising on drawdown a regulated activity, perhaps in the same way as transfers.
This brings us back to the requirement to buy an annuity at age 75.
Almost as soon as the ink was dry on the income drawdown legislation, there were calls to change the age limit. Some suggested removing it, others an extension to 80 or 85.
The need to buy an annuity was introduced in the 1921 Finance Act, but times have changed since then. People are living longer, investment markets are more sophisticated, and gilt rates (on which annuity rates are based) have fallen drastically.
There has been much lobbying over recent years, but we have still not moved on. The main barriers to any advance seem to be taxation, moral hazard and inertia.
The requirement to buy an annuity with all remaining pension fund money does mean crystallising assets into a stream of income, which allows the Inland Revenue to get its tax cut. This is particularly important for pensions because of their generous tax reliefs.
It would appear that any alternative to compulsory annuity purchase would have to allow a flow of tax back to the Inland Revenue.
Pension schemes as currently structured normally allow disposal of benefits on death to be free from inheritance tax. Again, this is of concern. Tax reliefs on pensions are not given to allow individuals to build up an inheritance-free pot to pass on to future generations.
(I am here grateful to Donald McCarthy, author of the Social Market Foundation's report Annuities: The Case for Change.)
There has been a suggestion that one factor preventing removal of compulsory annuities is that pensioners may feel inclined to spend their pension fund and then claim state benefits.
The report mentioned above argues that this is unlikely as individuals that find themselves in this situation have demonstrated a degree of financial awareness by accumulating such a fund and perhaps even managing it through income drawdow
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