While the average pension pot continues to languish around the £30,000 mark people need advice on how to get the most from their savings. Mike Morrison goes through some of the options
Everyone wants a level of pension that will keep them in the lifestyle to which they have become accustomed. This is unlikely to be the case and for most people the reality will be the state scheme supplemented perhaps by a small amount of private provision.
Surprisingly the average pension fund is very low, perhaps below £30,000 and with the advent of the new personal accounts scheme in 2012 small pension pots are likely to be a feature of the future.
For the sake of this article I will extend the definition of small pension pot to any pot of less than £100,000.
This raises a number of questions about how best to take the benefits from such small arrangements and I think that there are a number of key issues.
Now the first and most obvious point to make is to ensure the best possible annuity rate is used. Many pension providers who have offered contracts are not necessarily competitive in the annuity market. They will use the annuity as a default but their rate is unlikely to be the best. To some extent this is countered by the open market option which allows an annuitant to take the annuity purchase price (the pension fund) to the provider with the best rates. Sometimes the difference in income purchased could be as much as 30% in the annual amount.
The ability to look around the market at the time of buying the annuity is very important so it appears strange that over two thirds of people do not shop around. Sample annuity rates can be found on the FSA website, on Ceefax and even in the money pages of many of the weekend newspapers.
Another way of maximising the annuity rate might be to look at whether there are any factors in the client's life that could either make him eligible for an impaired life or an enhanced annuity. This could be a pre-existing condition that effectively shortens the annuitant's life or it could be a factor in their lifestyle that gives them the opportunity to apply for an enhanced annuity. Such factors could be health related, smoking related or even weight related. One annuity provider has even recently started to offer different annuity rates depending on the postcode of the client. The rationale being that where you live can play a significant role in your longevity.
The postcode route is a novelty way of considering external influences on longevity. Undoubtedly it will be difficult, not least in that some UK postcodes could cover a multitude of socio-economic groups living very close to each other, but long term we can expect more 'science' to be applied.
As well as choosing the best annuity rate it is important to select the right annuity characteristics. This choice is likely to involve a variety of contingent benefits for a spouse or dependant, escalation while in payment and the ability to guarantee payment for say five, or even ten, years.
All of these variables may be needed depending on the annuitant's circumstances but they all cost money and will considerably reduce a single life level annuity with no guarantees.
An appropriate balance will be needed to provide for a spouse or to protect against inflation bearing in mind the need to maximise income.
Another way of maximising income from a small pension pot might be to take as much of the pot as possible as a tax-free lump sum and then to use this to buy an immediate annuity. Annuities bought by pension schemes are known as compulsory purchase annuities while annuities available to individuals are known as purchased life annuities. The key difference is in the tax treatment, with instalments of a purchased life annuity including a return of capital meaning that for £1000 of purchase price the net income from a purchased life annuity should be higher than that from a compulsory purchase annuity. (This assumes that such a rate is available as there are fewer providers that are in the immediate annuity market).
Moving away from annuities for a moment, the alternative is to go into unsecured pension (income drawdown). The big question is whether it is suitable to use drawdown for smaller pension funds.
In answering this question it is a matter of looking at any other financial resources and the key factors to each client. Drawdown substitutes the certainty of annuity purchase with an income that could be higher but dependent on the underlying investment portfolio. The key issue will be the critical yield needed to produce the level of income needed and the client's attitude to investment risk.
For a smaller pension pot the key to any decision to go into unsecured income must be whether it is possible to maintain the purchasing power of the fund over time. Ultimately mortality drag at later ages is likely to mean that annuity purchase will eventually look more attractive.
It is perhaps worth mentioning here some of the new 'third way' products using derivative-based funds. These offer a certainty of income but at a cost.
So with a bit of thought, income can be maximised from a small fund but the issue might be that those consumers with small funds do not necessarily seek financial advice. Therefore, it is important that the government, with its means-tested pension credit, does not discourage people from even saving a small amount by having it all included in the means-testing equation.
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