With the population living longer, Scottish Widows' Ian Naismith discusses the different needs of today's retirees and how these needs can be satisfied by the various pensions vehicles
Until relatively recently, most people expected that retirement would be followed within a few years by death. There were always those who lived to a grand old age, but they were definitely the exception rather than the rule.
The position now is very different. The Government Actuary's Department recently estimated that men retiring at 65 in 1999 would live, on average, for another 15.3 years, and women retiring at 60 would live, on average, for another 22.7 years. For people with substantial retirement provision, the life expectancies will be even higher.
Like most averages, these figures disguise a wide variety of individual situations. Some people will die within five years of retiring, and at least as many will still be alive after 30 years. Except in circumstances where life expectancy is known to be short ' for example, terminally ill people ' an adviser must take both possibilities into account when clients reach the point of retirement.
The value of annuities
In recent years, there has been increasing concern about people who lose out because they buy an annuity but die shortly afterwards.
Such people clearly do not get good value from their pension.
However, it is sometimes forgotten that those who live to a very old age get extremely good value from an annuity. Those who opt for income drawdown or other options that delay annuity purchase may not get such good value.
The diagram below illustrates this point. It compares income to a 60-year-old male from an investment-linked annuity (without any guaranteed period or spouse's pension) with the income from a drawdown plan, which is assumed to continue indefinitely.
The initial income is approximately the maximum currently allowed for drawdown on the basis laid down by the Government Actuary's Department. Subsequent drawdown income is calculated on the same basis, allowing for the client's age and the remaining fund. The annuity income is determined only by the investment return.
The diagram, which is based on a £250,000 initial fund, 7% a year investment return and 1% a year charges, illustrates the effect of losing the mortality cross-subsidy in annuities, and why the Inland Revenue has been reluctant to remove the age 75 limit for buying an annuity. The rapidly increasing difference between income under the two options in later years demonstrates the effect of the phenomenon commonly known as 'mortality drag'.
Another way of looking at the issue is to consider the income that is sustainable under both options. With 7% a year growth, drawdown income of about £15,000 could be continued indefinitely. With the same growth, an annuity of over £21,000 would in theory be sustainable. This is 40% higher than the sustainable drawdown income.
Of course, currently drawdown cannot be continued effectively, and most offices will not allow a 7% growth assumption under an investment-linked annuity. But again, this illustrates the value those who live a long time gain from an annuity.
The mortality risk
Although a pure annuity undoubtedly gives the best value to someone who lives to a very old age, there is no denying that it represents poor value for those who die quickly.
In practice, most people will look for something between the two extremes, providing a good income while they are alive, but leaving something behind for any dependants. The right solution will depend on their individual circumstances. We can consider these in various groups.
Reduced life expectancy
First, we have people who are unwell when they retire. They are clearly the ones at most risk of losing out through buying a conventional annuity.
Such people essentially have two options. The first is to choose income drawdown or phased retirement, both of which potentially return the remaining fund value if the client dies. With drawdown, there is an income tax charge of 35% if a lump sum is paid out after the client dies. With phased retirement, there is no income tax charge.
However, phased also normally means there is not a large tax-free cash sum paid out at the start, which could be important if the client wants one last big holiday, for example. Another potential drawback with both is that the Capital Taxes Office may attempt to levy Inheritance Tax if the client dies within two years.
The second option for those who are unwell at retirement is to try to buy an enhanced (impaired life) annuity. This will be based on their actual life expectancy, rather than expectancy for a healthy person, so could be significantly higher.
The advantage of this is that they can take the tax-free lump sum, and then receive a higher income than is possible with income drawdown. In other words, they maximise their lifetime income, albeit at the expense of not leaving a lump sum from their pension arrangements after they die.
A second important group is clients who are in good health but are particularly concerned about leaving as much as possible for their spouse, children or grandchildren. This is the group that probably has the most interest in removing the current age 75 limit for drawdown, and in practice, many may choose drawdown in case they should die before reaching 75.
However, annuities present a number of options for this group too. The first obvious thing they can do is build in a guaranteed period, perhaps 10 years rather than the normal five. They can also build in pensions for a spouse and/or dependants, which in total can be up to the amount of the individual's pension.
A further option with annuities is to use them to accumulate other assets that can be left behind.
The client could take a level annuity, or an investment-linked annuity at the maximum starting level allowed. If the whole pension income is not needed to provide immediate income, part of it can be invested (as far as possible in tax-efficient vehicles such as Isas), and can be passed on to the next generation in due course.
Another option introduced by the new personal pension contribution rules is to invest the surplus in a personal pension (up to a maximum of £3,600 a year or possibly more for five years if justified by earnings immediately before retirement).
This attracts tax relief, and if the client dies before taking benefits from the new plan, there should be no Inheritance Tax liability on the pension fund. Of course, this particular option stops when the client reaches 75.
Clients in this final group are ideal candidates for annuities. They are generally not concerned about leaving money behind them, and want to maximise their own income.
Unless they have a particular need for flexibility, they should probably invest in an annuity as soon as possible after they retire. Even where flexibility is required, this can also sometimes be achieved through an annuity now.
Mixing and matching
The above ideas implicitly suggest that only one of the possible solutions will be selected. Of course, this is by no means necessary if the fund at retirement is high enough.
Some clients may want to use drawdown to provide short-term death benefits, but also buy an annuity immediately to secure a good lifetime income.
Others may choose to buy more than one annuity ' for example, a conventional one to provide security and an investment-linked one for growth potential, or a level one for high initial income combined with one starting lower but providing regular increases.
The client's individual circumstances and attitudes are critical to the decision, and the value of professional advice at retirement is now greater than ever before.
l There is increasing concern about people who lose out because they buy an annuity and die shortly after.
l Individual circumstances are critical to eventual annuity choice.
l People who take income drawdown risk losing the benefits of mortality drag.
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