Annuities have had a difficult time in recent years. However, Peter Magliocco believes they can inject real flexibility into your retirement planning
Maximising the return from the funds available to you in retirement is essential. The proficiency of the masses to accumulate further meaningful wealth once they have finished work is limited, and even once hoped for family inheritance is dwindling due to the rising costs of providing long term care.
On retirement a one off opportunity exists to select a pension commencement lump sum (more widely known as a tax free lump sum). If the PCLS option is not selected then the entire income (the pension) will be taxed under PAYE at the individual's highest marginal rate (currently, 10%, 22% or 40%). In the main, the tax free lump sum is selected with the proceeds in many cases ending up sitting on deposit.
Money placed on deposit, (generally in bank or building society accounts), is often the default option for those in retirement who find themselves caught between the desire to maximise investment returns but equally understanding that higher returns generally equate to greater investment risk.
The frequently held perception is that deposit accounts return the headline rate (AER) quoted by the institution, currently say 5.8% (gross).
Often what is overlooked is that if you pay tax this still needs to be deducted, which for a basic rate taxpayer reduces the return to 4.64% (20% reduction) and for a higher rate tax payer the return drops to 3.48% (40% reduction). For example, £20,000 held on deposit for a basic taxpayer, and assuming these returns would mean a drop in income from £1,160 to £696 per year.
In addition the effect of inflation, currently running at 4.6% (RPI - at a 16 year high) also needs to be factored into the overall return. While following this train of thought it is also worth remembering that returns on deposit vary over time and locking in money over the longer term may be difficult.
The benefits of annuities
With income, for many, being the overriding requirement in retirement, purchased life annuities (PLAs) provide the certainty of a regular income with the additional advantage of a favourable tax concession.
PLAs for the purposes of tax are broken down into two elements, capital and interest. The capital element of the annuity is treated as a return of the annuitant's original investment, having been deemed to have been taxed already during accrual, and is therefore tax free. The income element is then taxed as savings income, which is 20% for basic rate taxpayers. Higher rate tax payers will pay a further 20%.
As an example a 65 year old male purchasing a "no frills" PLA with a fund value of £20,000, will receive a net annual return of £1,204 for his lifetime. Statistics from the Government Actuary's Department suggest that the average life expectancy for our example male is 16 years, thus leading to a cumulative income of £19,264. This compares favourably to our £696 per year return from a competitive deposit account (remembering however that the return will vary over time).
It is at this point that I hear the cry of the inflexibility of annuities over deposit accounts and the lack of control over capital once an annuity has been purchased. While of course, the purchase of an annuity does require the passing of control of capital from the annuitant to the annuity provider (insurance company) options can be added to the contract to mitigate the effects of early death. Guaranteed periods and the option to protect the initial purchase price, "capital protection" can be attached to the annuity contract at outset.
Guaranteed periods, typically for five or ten years, allow the income from the PLA to be paid to the annuitant's estate in the event of early death, in these examples for either five or ten years from the commencement of the contract. Capital protection on the other hand provides protection to ensure that at least the value of the purchase price (the initial funds to purchase the PLA,) less the pension paid to date of death, is paid back to the annuitant's estate.
Example incomes for a 65 year old where these options have been incorporated and investing £20,000, again to purchase a conventional PLA are shown below:-
Guaranteed for five years £1,195 per year net (assuming higher rate tax)
Capital Protected £1,118 per year net (assuming higher rate tax)
While looking at PLAs it is important to mention that the income can be further increased by taking into account the annuitant's health. Just Retirement, a specialist operator in the retirement market, claims that at least 40% of those approaching retirement age (60 plus) would qualify for some sort of enhanced income in retirement. Conditions such as diabetes, raised cholesterol, high blood pressure and obesity can all be considered and may result in an increased income. In our 65 year old male example, the same purchase price could secure a net income of £1,275.38 per year if qualifying conditions are met.
While considering health issues it is also worth noting that PLAs can be used to assist in the planning of income shortfalls for both residential and nursing home care. With the cost of even the most ordinary residential care home requiring annual fees of around £25,000 or more it is quite easy to see how guaranteeing the payment of fees through a voluntary annuity can become an attractive option.
An alternative to a PLA is an immediate needs, or care fee annuity. These are currently available only through a limited number of insurance providers. These largely operate in a similar way to ordinary purchased life annuities however, if funds are paid directly to the care provider (nursing or residential care home) then the payment is made gross with no deduction for tax.
For example, funding a shortfall in residential care income of £28,000 per year will currently cost around £80,668 from AXA PPP (based on a 90 year old male, single life with no escalation).
With the size of the UK at-retirement market estimated as being around £9 billion there is enormous scope to consider the various annuity options and how they can assist with financial planning. The ultimate solution may not of course always be to annuitise but there are distinct advantages in exploring these often under-rated financial products.
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