While further detail is required on many areas, the Government's recent consultation paper on modernising annuities represents a better way forward than many of the other choice-restricting proposals outlined of late
Christmas came late this year ' but it was worth the wait. To be clear, by Christmas I mean the time by which the Government's consultation paper on annuities was originally scheduled to appear. The paper was foreshadowed in the Chancellor's pre-Budget speech early in November and it eventually appeared in early February under the name Modernising Annuities.
It is difficult to remember that there was a time, before the pre-Budget speech, when the idea of a Government consultation paper on annuities seemed about as likely as the FSA producing one of its major papers without a reference to consumers in the title.
Received wisdom is that the Government was happy to allow product providers to continue to develop innovative products within the current rules. Several products of that type did appear but they were only suitable for those with very large retirement funds.
Meanwhile, the only show in town dealing with the reform of retirement income options was the one that started with the proposals in the Choices report prepared by a working party chaired by Oonagh McDonald and published in 2000. They later found their way into a private member's bill under David Curry's name with a very high place in the ballot. It received its second hearing in early January.
The Government criticised the Curry proposals as only being suitable for the better off. Perhaps it was the need to find a solution with a more universal appeal that spurred the Government on to publishing its consultation paper.
The paper defends the current policy of requiring, at some stage, the purchase of an annuity and it argues that 75 is the correct latest age at which this should happen. The arguments for compulsory annuitisation are both social (you cannot be allowed to spend your entire retirement fund and then rely on taxpayers for support) and economic (at some point an annuity is going to be better value for money than drawdown).
It was interesting to see, in connection with the latter point, a long description in the paper of mortality drag ' a subject that had only previously been found lurking in the dark corners of actuarial papers.
Moving on to possible reforms, the paper starts by laying down some principles that the Government believes should not be tampered with in any new solutions. One of these principles is that 'pension savings should not become a tax favoured savings vehicle for non-pension purposes'. This has a bearing on the debate on inheritability later in the paper.
Any part of a retirement fund passed on to dependants on the death of the retired person should be subject to a tax exit charge to cancel out the effect of the tax-sheltered environment in which the pensions savings have been growing. The same rules would have to apply to any capital extraction form the fund while the retired person was alive ' an option considered in the paper but not supported by the Government.
It is easy to see why the Government would want to apply a tax exit charge but there is a flaw in its argument. It is possible to pass on to your dependants, free of any tax exit charge, any funds you have accumulated should you die before you have converted your retirement fund to an income-producing vehicle. A somewhat anomalous cliff-event therefore applies to your fund inheritability position as you move from retirement minus one day (no tax charge) to retirement plus one day (tax charge).
It is possible to determine where the edge of that cliff might be (at least up to age 75) by constructing your retirement funds in a certain way but, once again, that option is really only available to the better off.
By now you might be wondering what good news there was in the paper ' why was it worth the wait? If you were hoping to see the abolition of compulsory annuitisation, you will have been disappointed. On the other hand, if you wanted to see more choice around the annuitisation options and, in particular, the opportunity to not fully annuitise when you retire, you will welcome the paper ' especially the part dealing with limited period annuities.
To illustrate this interesting proposal, assume you have a client who has reached 60 and has built up an average-sized retirement fund. He is scaling down his working hours but expects to be earning for another five years or so. He may even work beyond that but cannot be sure at this stage.
With a limited period annuity, he can use part of his retirement fund to buy an annuity for five years only at a level that he feels necessary to supplement his employed income. The balance of his retirement fund can remain invested in whatever asset mix he wishes.
After five years, he can review his position. If he is still working and likely to do so for a few further years, but will be scaling down his hours even further, he could use part of his remaining retirement fund to take out a three-year limited period annuity but for a higher income if he wishes. Once again, the balance of his funds remains invested. This position can continue until he wishes to buy a throughout life annuity. He must do this by 75 at the latest.
Although this example demonstrates the benefits of limited period annuities when there is a wish to vary the income, they could also be used to provide non-variable income but not annuitise fully at outset. The effects of mortality drag would have to be considered here but the real point is that people now have more choice.
All of the Government's proposals add to the existing range of options and bring the flexibility, currently only available to the few with large retirement funds more within the range of the investor with medium-sized funds.
Adding more choice has to be good for consumers especially if it allows more companies to enter the market and increase competition.
Other forms of annuity development will also be possible under the proposals but, rather than have prescriptive and detailed legislation, proposals are for there to be there be an enabling legislation to allow approval of arrangements that meet an agreed list of criteria. This will allow the creativity in new products we are seeing already but without the strict legislative requirements.
The paper also raises other points that are a consequence of greater choice becoming available. Those who already have an annuity may wish to take advantage of the new options so should they be allowed to switch out of their current arrangement? There is a conflict here between increasing consumer choice and breaking the sharing of risk agreement that every existing annuitant has, in effect, entered into with his or her fellow annuitants.
This is not an easy one but complete freedom to exit an annuity at an average price cannot apply since some doing so may know that their expectation of life is now likely to be less than average. Underwriting at the point of exit simply will not work. The paper is looking for views here and suggests one possible solution ' allowing exit only on predetermined dates.
The other question considered is how you can increase public awareness of the wider options that will be available. This is not just a question of differences in product design but also about the different risks attaching to each product.
Fixed or guaranteed annuities are straightforward in that the future payment is known with certainty (although there is still an inflation risk) but investment linked annuities and annuities which are purchased in stages (like limited period annuities) will have a range of possible outcomes.
Knowing where the likely upper and lower part of that range will be for each option will be an important part of the decision-making process and something other than just descriptive text may be necessary to illustrate the point. Current disclosure rules do not cope well with this sort of information and it will be a challenge to see if something can be developed that does a better job.
In summary, this paper is to be welcomed as a pragmatic and sensible contribution to the debate on bringing greater choice to retirement income. It is certainly a much better way forward than some of the more choice-restricting proposals we have seen from other quarters.
One of the key recommendations in the paper is that pensions should not become a tax-favoured savings vehicle for non-pension purposes.
If people were hoping to see the abolition of compulsory annuitisation, they are likely to be disappointed especially if it brings new players.
Adding more choice to annuities has to be good for consumers, especially if it brings new players to the market.
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