The 6th April 2006 was a watershed moment for pension planning. This date, known as ‘A’ Day, introduced a new whole pensions’ regime, and in the process rewrote many of the accepted rules on how we save for retirement.
Much has already been written about some of the quirks and opportunities in the system, in particular the new investment freedoms for Self Invested Personal Pensions (SIPPs). In this article I want to focus on the changes that are happening around the provision of retirement income – sometimes known as “decumulation” (as opposed to the pre-retirement accumulation phase) – driven partly by A Day rule changes, partly by the investment environment, and partly by demographics.
From annuities to drawdowns
First, some background material. Up until the mid 1990s, the only real choice for anyone with a maturing pension plan that wasn’t a final salary company pension scheme, was to buy an annuity. Annuities came in a few shapes and sizes – single or joint life, with or without inflation proofing, and perhaps the option of a guaranteed payment period – but they weren’t what you would call exciting.
This all got much more interesting when the government introduced the option of a ‘drawdown plan’ in the mid 1990s. With drawdown you have control over where your money is invested, and how much income you can withdraw. You also get much more attractive death benefits than an annuity. The government imposed upper and lower income limits on the drawdown plan. Initially this was set at a maximum of 100% of what an annuity would pay, with a minimum of 35% of this figure.
Come A Day everything stepped up a gear. The maximum income you can now take from a drawdown plan is 120% of whatever an annuity will pay, while the minimum is zero. This means that if you want to strip money out of your pension fund, then you can do so at what will probably be an unsustainable rate.
A 65-year old man could draw an income of around 9% per annum; factor in some charges, and you are looking at a required investment return of perhaps 11% per annum or more. So if you want to empty the pot, then it may take a few years, but you will almost certainly be able to do it, if you put your mind to it. Conversely, if you just want to take your tax free lump sum entitlement of 25% of your pension fund, and defer drawing any income, then you have this option too.
I think that this latter option will become increasingly popular for several reasons. The government has in effect given investors carte-blanche to withdraw their tax free lump sum at age 50 (55 from 2010), and to leave the balance of their pension fund invested and growing until they need to draw on it, perhaps ten or fifteen years later.
Given the multitude of demands pressing on the finances of so many people these days; unsecured debt; university costs for children, endowment shortfalls and so on, it seems to me inevitable that some will take up this quick fix to their financial circumstances.
Death benefits for drawdown plans are a definite attraction, compared to the relatively inflexible terms on offer from an annuity. The main problem with an annuity is that once you have made your choices, you are stuck with them for life. With a drawdown plan, nothing needs to be decided in advance. On your death, your surviving spouse has the choice to; carry on with the drawdown plan as if it were their own; take the entire fund and buy an annuity for themselves with it; or take the fund value as cash, less a 35% tax charge.
Why annuity incomes are under pressure
For annuities there is continued downward pressure on income rates from three separate quarters. Firstly, interest rates have fallen, and annuities look like pretty poor value compared to the high payouts of yesteryear. 7.5% looks much less fun than 14%.
Then we have mortality experience, and the fact that everyone is persistently not dying; to the extent that insurance companies have had to substantially revise the rates they can offer on annuities. Life expectancy at age 65 has risen at a rate of three months a year over the last quarter of a century, adding several years on to the average annuity payment period. This means that income rates have been, and still are being, adjusted downwards to compensate for the longer payment periods. In addition, the commercial pressures within the annuity market have reached something of a tipping point.
Consider this: you run an annuity business and you price the annuity rate you are prepared to offer your customers on the basis that you will get a good mix of the population doing business with you; you will get fit and healthy people who will live a long time, and you will get unhealthy people who will die younger. The latter group help to subsidise payments to the former group, and allow you to offer an average rate to them all.
Now, a competitor has set up business next door, and they are offering better rates than you, but on condition that all their customers have a life shortening medical condition. Your competitor scoops up all the unhealthy people, and you are stuck with all the fit people. In this situation you have to either reduce the rates you offer, or follow suit and start offering the same kind of deal; high rates for unhealthy customers, and low rates for the healthy.
In the past year we have seen a growing trend towards this segmentation of the annuity market. More and more insurers are launching variations on this theme, such as separate smoker and non-smoker rates; underwritten rates – where they look for evidence of compromised health and life expectancy; we have even seen postcode rates, on the basis that people in Kensington do, on average, live around 11 years longer than the inhabitants of Glasgow (some sections of which have roughly the same average life expectancy as the inhabitants of the Gaza strip).
Should you defer purchasing an annuity?
Clearly, if you are healthy and wealthy, then you are going to be increasingly disinclined to purchase a conventional annuity at age 65; put crudely, you may be better off waiting until your mid seventies, when your health starts to deteriorate, and you may secure a better rate. Until then, you may choose to stay invested in a drawdown plan, managing your investments.
The challenge is to balance the conflicting risks faced in retirement. Living too long or dying too soon. Offsetting the corrosive effect of inflation, without taking too much investment risk; too much and you could lose money, too little and you might miss out on growth. Maintaining access to capital, and the freedom to change your mind, whilst securing certainty of an income stream. Whatever decisions you reach will be a compromise. New and ever more creative solutions are being offered up to investors.
Last year’s big new thing were variable annuities, which are roughly a hybrid of drawdown and a conventional annuity. They offer investment market exposure, with the potential benefit of growth that can bring some death benefits, and the certainty of guarantees on the level of income paid out. It looks like an attractive package, and in principle they are a good idea. Unfortunately, the products we have seen so far, all of them imported from America, have struggled to overcome cost issues that can have charges pushing up towards 4% a year.
For now, I am inclined to the view that for the majority of investors, the same balance of investment risk combined with guarantees on income can be achieved by mixing and matching a drawdown plan with an annuity yourself.
Incidentally, I think that the much maligned ordinary annuity is a better product than many give it credit for. It does one thing very well, which is to guarantee you an income for the rest of life, no matter how long that is. Nothing else does this. The virtue of such a guarantee is that it leaves you with more flexibility to manage the rest of your money creatively, secure in the knowledge that your annuity will keep paying out.
We also now have a product (technically it’s not a pension) which doesn’t start paying out until you are 75 at the earliest, and can run on until you are 100. It is structured in such a way that the early years payouts are relatively low, but every extra year that you live brings a higher payout, and in theory those people who reach 100 will do very well out of it.
Lurking in the background of any planning around retirement income strategy is the cut-off point of age 75. The government requires investors to buy an annuity by the age of 75, thereby putting a time limit of post retirement investment strategies. There are a couple of ways around this problem, involving some continued control over your investments, but with less flexibility over the income withdrawals and with much tighter death benefits.
There is a huge amount of interest in the retirement market as a whole, so I think that the product innovation will keep coming. From the pensions industry’s point of view, it is much more fun talking to someone with £200,000 to invest, than to someone with £200 a month to save. And there are an increasing number of people to talk to; in 2012 alone, 800,000 people will hit retirement as the post war baby-boom generation all reach the end of their working lives. The ‘at-retirement’ market is already worth around £12bn a year and it will grow fast from here.
There is one universal truth in all of this; however large or small your pension fund, the one thing you absolutely must do in the run-up to retirement, is to think hard about what kind of income you will want, and make sure you shop around for the right solution.
By Tom McPhail for The Daily Reckoning