Limited period annuities offer pensioners in the early stages of retirement flexibility but the only product on the market has flaws
Limited period annuities have been touted by the Government as one way of improving the attraction of the pension annuities market and helping alleviate the plight of those retiring, hard hit by the massive fall in annuity rates in recent years.
In the early stages of retirement, pensioners often need a bit of time to get a clearer idea of what the future holds. The use of a limited period annuity for, say, the first five or even 10 years would enable them to assess their income requirements more accurately when life in retirement has settled down.
The main rationale behind limited period annuities is that they could provide a great deal more flexibility. Instead of making a commitment for life by buying a conventional annuity at a time when the future may seem unclear or uncertain, annuitants would be able to make a relatively short-term decision that could be adapted later on to meet any change in circumstances, economic conditions or lifestyle.
The death of a spouse, for example, would enable a fixed joint life annuity to be replaced by a single life annuity costing a lot less. Delaying a lifetime commitment could also be particularly useful to someone who suffers from deteriorating health as they get older. They might be able to take advantage later on of the enhanced rates available for impaired life annuities.
Limited period annuities have been available as investment products for some time. At one stage, when annuity rates were higher, they were widely used in back-to-back arrangements to fund regular contributions to endowment policies.
However, the response so far from insurance companies selling annuities has been lethargic to say the least. It had been hoped the Government's suggestion of new types of pension annuities would have stimulated insurance companies to unveil plans for new products but they have remained strangely silent.
The lack of response may well reflect the view that the Government has not really worked out whether its proposals, including the use of limited period annuities, are going to achieve its objective of making the annuity market more competitive.
So far, only one company, Canada Life, is actively using a form of temporary annuity as part of a pension package, it is similar to a drawdown scheme. Called the Annuity Growth Account (AGA), it was launched in 2000 to attract pensioners looking for more flexibility following the fall in rates for conventional pension annuities to desperately low levels. One feature of the plan is that, at the age of 75, investors are able to defer being forced to take out a conventional pension annuity until they reach the age of 85.
The basis of the AGA plan is that short-term (five-year) annuities generate a lot more income than lifetime annuities because they run for a known, much shorter, period, so the same amount of income can be generated for a much lower outlay. This leaves the balance of the pension fund available for investment in funds to provide growth, which hopefully will not only equal but exceed the cost of the limited period annuity.
The proceeds from a money purchase pension fund, with or without the tax-free lump sum, are divided into two separate parts: an annuity section providing income and an investment element aimed at growth. The level of income required can vary between the minimum of 50% that would be generated by a lifetime annuity up to 100%. The lower the level of income selected from the initial annuity, the greater the amount available for investment to fund growth for the future.
Growth in the value of the investment element is boosted by the payment of a survival bonus at the end of each five-year period to take into account that the annuitant is older.
Investors in the AGA plan benefit from the mortality subsidy generated by lifetime annuities as a result of the premature death of some annuitants below the average age on which the rates are based. This is because the AGA plan is in fact a lifetime commitment giving pensioners more flexibility, with a mixture of annuity income and investment funds in one package.
Like normal drawdown schemes, there is a risk of losing money, rather than adding value, especially if riskier funds are selected within the growth section. This in turn could lead to a fall in the level of income. Much depends on the performance of the investment funds selected, ranging from higher risk equity-based funds to theoretically lower-risk bond or cash funds.
At the end of each five-year period, investors can either take out another five-year annuity or decide the time is ripe to switch to a lifetime annuity. This can be continued up to 10 years after the deadline of 75-years-old, when investors normally have to purchase a pension annuity.
They cannot withdraw from the scheme so the ultimate income level is dependent upon Canada Life's annuity rates continuing to be competitive and the range of investment funds available under the plan performing adequately. Herein lies the problem. In our opinion, the use of Canada Life in isolation is restrictive and inflexible.
Under proposals in the Green Paper on pensions, issued in December by the Inland Revenue, investors in drawdown schemes may no longer be required to purchase an annuity at age 75. Instead, the requirement would simply be for all funds to be used to draw benefits either by purchasing an annuity or by means of drawdown.
However, any drawdown funds would have to be used to provide income for a spouse and/or financial dependants if the investor dies after age 75. No lump sum could be paid out and if there were no spouse or dependants, the funds would revert to the insurance company.
The possibility of insurance companies being given a windfall profit they have not sought has already brought considerable press criticism and may make the Government change its mind, although it appears determined to stick to the age 75 deadline.
Greater availability of limited period annuities for pension funds would provide investors with a lot more flexibility. However, they might not be a particularly attractive alternative for pensioners unless used in a way in which they benefit from the mortality subsidy.
It is also true to say that putting off a decision by using limited period annuities may not necessarily work out better. It is a double-edged sword. Instead of lifetime annuity rates improving, things may get worse rather than better in the years ahead.
Longer life expectancies are likely to continue putting downward pressure on annuity rates, even if interest rates do rise, and the investment element could be hit by continued volatility in the stock markets. Nevertheless, a wider choice of options should be welcomed by the increasing number of pensioners being caught in the annuity trap.
Alun Evans, marketing director at Carr Sheppards Crosthwaite
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