While the Government is right to acknowledge that annuity reform is a delicate issue that requires careful handling, that is no reason to keep archaic rules designed for previous generations
I have been writing occasional articles on annuities for the past 10 years, starting when advisers woke up to the fact that under the new 1988 rules for personal pensions, it was possible to stagger the drawing of tax-free cash and pension. This led to the technique now called 'phased retirement'.
The phasing only provided a partial solution. What clients, particularly those with larger funds, really wanted was more flexibility in the timing and amounts of withdrawals and in the investments underpinning the funds. In addition, they wanted to be able to bequeath their accumulated fund on death to their dependents.
These considerations led to two genuinely innovative attempts in late 1993 to design a radical type of annuity ' the managed or flexible annuity. The two products, designed by Equitable Life and Provident Life (now Winterthur), certainly pushed back the frontiers. But, unfortunately, the Inland Revenue decided these products were not annuities. It controversially decreed that they were not 'safe, stable, regular and for life' ' the Revenue's hitherto unknown criteria for defining an annuity. The Inland Revenue also raised concerns as to whether the capital was actually transferred from the pensioner to the provider.
It is interesting to look at the Revenue's interpretation in the context of today's market. This year has seen three types of annuity ' the Annuity Growth Account from Canada Life, the Flexible Lifetime Annuity from Prudential and, the most recent, the Open Annuity from London & Colonial. All three have apparently been accepted by the Inland Revenue as an annuity for pensions legislation purposes, which leads me to conclude that the goalposts may have moved as far as the Revenue's 1993 definition is concerned.
Yet somehow I feel sure that this is not the end of the road. To an extent, the current Government has acknowledged this by stating the following in its manifesto: 'We will continue discussions on annuity reform to ensure tax rules do not unnecessarily restrict the development of annuity products and markets.'
This suggests that previously sacrosanct provisions, such as the 10-year guarantee rule, the ability to redefine dependency provisions and, most importantly, the prohibition on commutation may yet find their way onto the agenda for reform.
The annuity rules were set many decades ago, at a time when the financial and demographic pressures were very different from today's climate. In just 30 years, the life expectancy of a male aged 65 has risen from 12 years to more than 15. About 30% of those born in 1935 will still be alive in 2020 and about 5% can expect to reach the age of 95.
Living much longer brings its own problems. In particular, although people are living much longer, many require care as a result of impairments such as Alzheimer's disease. The Government is right to acknowledge that this is a complex issue and requires thought and careful handling. However, that is not an excuse for hanging on to rules that are archaic and designed for previous generations.
Recently, a lot of academic work has been undertaken on this subject. The Choices Project, produced by the Retirement Income Working Party under Oonagh McDonald, put forward the idea of minimum retirement income (MRI). Essentially, part of an individual's pension fund would have to secure an index-linked annuity of £70 per week, which, together with the basic state pension for a single person, would provide an income of about £140 per week. Once the MRI was secured, more innovative methods of dealing with the Residential Fund were proposed.
The drawback with these recommendations is the high cost of securing the MRI annuity. Since this would currently amount to roughly £50,000, the practical impact would be little different from today's situation for many individuals with smaller funds.
A more recent report by the Faculty & Institute of Actuaries (F&IA) looks at an alternative model, producing an interesting extension to the annuity debate in the form of a paper called Extending Retirement Choices. As the author states, the F&IA's aim is to demonstrate that the key to better annuity provision is to offer more choice at retirement without increasing the likelihood of reliance on State benefits.
In the paper, the F&IA identifies seven different customer needs (see table below). Of particular interest is the proposal for a new style of annuity option called a personal distribution plan (PDP).
Under the PDP, a minimum retirement income (including State benefits) is determined ' similar to the Choices report. If the retirement fund is more than the cost of an annuitising the non-State MRI, no compulsory purchase of an annuity is required. The fund can remain invested and income drawn down from it until such time as only the MRI can be secured. The right level for MRI is debated and left for further discussion.
Some controls are suggested over the investment freedom as the fund approaches the point of annuitisation. A key proposal is the provision of regular, better and more meaningful information ' the suggestion is to use a combined benefit statement that would be prepared and issued regularly by the PDP manager.
There is more than a passing resemblance in the PDP to the relatively new retirement option arrangement in Ireland. Initial feedback on the new Irish regime suggests it has been successful, with strong growth in savings spurred by the ability to avoid purchasing an annuity. Those with smaller funds apparently continue to select an annuity normally. Consideration of the new Irish regime leads onto the position in other European countries and elsewhere. The danger in looking at countries such as Australia, Chile and some of the more progressive European nations is that there are significant variations in key areas such as the economy and the power of the end ' the consumer. Although the implications of the demographics are similar ' an ageing population and reducing numbers to support it ' the severity of the problem remains. Annuity compulsion is exceptional, although in many countries the traditional lifetime or temporary annuity remains a favoured choice for many of those retiring.
Looking at all these trends and arguments, there seem to be a number of key issues:
l The Government needs to clarify its thinking on pensions and in particular the extent to which it wishes to encourage self-provision through tax incentives.
l The logic of compulsory annuitisation in the absence of compulsory pension savings looks increasingly flawed. If compulsory saving is introduced, then that could be the time to change the current compulsory annuitisation rules ' annuitisation would only apply to compulsory savings in future.
l The proposals put forward to date are mainly relevant and of benefit to those with larger pension funds ' more than £75,000. By number, these remain the minority and it looks increasingly unlikely that there is one reform that will suit all.
l The current annuity rules are outdated and unnecessarily complex. There needs to be a wholesale review of these rules and the new simplification initiative would be an ideal time to tackle this. The recent new products are all designed to suit the current regime, and perhaps the biggest issue is their complexity. It would be hard to describe them as either transparent or consumer-friendly, both of which are pre-requisites of this growing market.
l The Government can no longer look at pre- and post-retirement as two separate regimes with a total disconnection at the point at which someone starts taking income from their fund. Where is the logic, for example, that dictates that the size of the benefit paid on death can vary dramatically depending upon whether the individual dies the day before or the day on which they start drawing income? The same arguments apply to the tax treatment and investment regimes.
From the above comments, it seems clear that there is an overwhelming case for reform. The problem is that to tackle annuity reform in isolation of the bigger pensions savings and simplification reforms may simply perpetuate the current detached approach to pre- and post-retirement issues.
My fear, however, is that the size and scale of the issues will lead to further procrastination and inertia. Encouragingly, the issues are at long last receiving the attention and study that they deserve.
The Government has pledged to continue discussions on annuity reform.
This means previously sacrosanct provisions may get onto the agenda for reform.
The logic of compulsory annuitisation in the absence of compulsory pension saving looks increasingly flawed.
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