In the March Budget, the Chancellor dashed the hopes of pension advisers when he declined to remove ...
In the March Budget, the Chancellor dashed the hopes of pension advisers when he declined to remove the restriction on drawdown plans that currently forces investors to convert to an annuity by the age of 75.
The inflexibility of drawdown to sustain investors' requirements beyond the age of 75 should by default breath new life into an under-utilised and under-researched product the investment-linked annuity.
In practice, there are four broad options at retirement for those with a defined contribution (DC) plan. Advisers should consider these on a mix-and-match basis and with full regard to the proportion of the client's total income and assets the pension fund represents.
l The client can buy a conventional annuity from an insurance company. This provides a guaranteed income for life, which can be fixed or rise annually. The conventional annuity effectively locks your client in to current gilt yields.
l If the client has other sources of income, he or she could leave the pension fund in the pension plan until age 75 at the latest. The fund will continue to grow virtually tax-free and is an effective inheritance tax (IHT) planning arrangement, but the client will not be able to take the tax-free cash or draw an income.
l The client can buy an investment-linked annuity and hope to improve the level of the annuity income through good investment returns. Most providers allow their annuitants to convert to a conventional annuity at a later date although without access to the open market option.
l The client can transfer to a drawdown plan, which offers full exposure to the stock markets as well as IHT planning opportunities.
Assuming the client needs an income, he or she will have to 'vest' part of the entire fund. Any unvested portion remains outside the tax net. The vested portion can generate tax-free cash and provide an income through the purchase of an annuity, a transfer to drawdown, or a combination of these arrangements.
Conventional annuity risks
The point that often confuses clients who have come from an investment-based pension environment is that the conventional annuity is a pure insurance product and is based on the pooling of risk in this case expected mortality in the light of age, sex, and state of health, among other factors. When clients become annuitants they share that mortality risk with other lives and are protected against the risk that they may outlive their income.
The problems associated with conventional annuities are well documented in particular, the link to interest rates and the yield on long-dated gilts and bonds, the instruments insurance companies buy to back the guaranteed income stream. William Sallitt, head of the retirement team at independent adviser Carrington Investment Consultants, says: "Although the annuity may be structured to increase in payment each year, there is no underlying growth." In fact, the annual increase can only be achieved by lowering the initial income.
Stewart Bayliss, director of retirement specialist Annuity Direct, says: "When you buy a conventional annuity you are effectively locking in to gilt yields and market assumptions on interest rates on the day you make your purchase. Once you have made the purchase, you will not be able to unlock your fund."
While for many pensioners the guarantee is paramount, for some particularly those who take early retirement the price of that guarantee may be unacceptably high. Bayliss warns: "Clients in their late 50s or early 60s might be retired for 25 years or more. We would argue that to lock in to gilt yields at such a time is a very risky investment decision."
Investing in real assets
Falling gilt yields and increasing longevity have forced down annuity rates substantially in recent years. According to The Annuity Bureau, in 1990, a 65-year-old man could have secured an annuity income of £11,000 a year with a fund of £100,000 (including annual increases of 3% and a 50% spouse's pension). By 1995, that annuity rate had fallen to about £8,000. If a client made the same purchase last year, they would have secured an annual income of just £6,000.
This perceived deterioration in annuity rates has encouraged those coming up to retirement to look for ways to avoid locking in to gilt yields and to maintain a link with real assets in the hope of improving their income, albeit at varying degrees of risk.
After a slow start, and despite the Equitable's closure to new business, the investment-linked annuity market is growing steadily. Unfortunately, as far as hybrid insurance/investment products go, this is about as complicated as it gets. The investment-linked version is still an annuity and therefore the requirement to convert to a conventional product does not apply. The downside is that as an annuity, the IHT planning opportunities are slim. Unless clients buy a spouse's income and a guarantee, the fund reverts to the insurance company on death. The upside is that the income is boosted by the effect of annuitising that is, taking advantage of the cross-subsidy from pooling mortality risk with other annuitants.
Unit-linked annuities versus drawdown
Unit-linked annuities that provide access to external managers can be seen as a simpler and potentially cheaper alternative to drawdown, provided investment choice rather than IHT planning is the client's primary aim. Clearly, the client who wants to use the pension fund to hold individual equities and bonds would select the drawdown arrangement.
The income under the unit-linked version is based on an assumed growth rate (AGR) and will therefore fall if the expected returns do not materialise. Depending on the volatility of the markets, the income may fluctuate with each payment.
At present, only Canada Life, Merchant Investors and Scottish Widows offer external fund links and each of these products is different, so a like for like comparison is not appropriate. Allied Dunbar offers its own managed fund. The Prudential, which offers a with-profits annuity, is expected to launch a unit-linked product with external unit linked options shortly. This will be a welcome boost to competition in the market.
With-profits: an appropriate choice
According to a recent survey by Pensions Management (February 2001), with-profits annuities are sold by Britannic Retirement Solutions, Legal & General, Liverpool Victoria, Norwich Union, Prudential, Scottish Mutual, Scottish Widows, Standard Life and Sun Life.
To date, these funds have taken the lion's share of the investment-linked annuity market and for good reasons. The asset allocation of this type of fund (typically about 75% in UK and overseas equities with the rest in gilts, bonds, cash and property) is considered prudent for retired investors, while the fund reduces volatility through the smoothing mechanism.
Several companies provide a guaranteed minimum income, although if a client is interested in this feature it requires careful investigation as it is usually at the expense of potential growth.
Unfortunately, the way the income is calculated is designed to defy the intelligence of the average investor and even advisers can be hard pressed to describe the methodology lucidly, particularly when they are also required to explain the charging structure. But, as the cynics argue, that's with-profits for you.
The annuitant's income is based on the assumed bonus rate (ABR), which is selected when the contract is taken out and typically may be anything from 0-5%. Most annuitants opt for a midway point such as 3.5%. Where the ABR is higher than the actual bonuses achieved by the fund, the annuitant's income will fall. The income is reset on an annual basis.
While the with-profits structure has been criticised in recent years for lack of transparency and the significant asset allocation to gilts and bonds, advisers suggest it serves a valuable purpose in retirement.
Julie Sebastianelli, a senior manager with Arthur Andersen, says: "The real downside of unit-linked funds is volatility. In retirement with-profits is an option for some investors because it does reduce risk."
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