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What type of pension funds can buy an annuity?
Not every pension arrangement can purchase an annuity.
A member of an occupational final
salary pension scheme is provided an income from the
employer based on the final salary and years of service.
Although it is possible to transfer from this scheme to
a private pension arrangement, this process would be subject
to passing the GN11 test.
Certain pension arrangements must buy a pension annuity.
These include a personal
pension, stakeholder pension, retirement annuity policies
(RAPs), section 32 policies and free standing additional
voluntary contribution (FSAVC) plans. If the pension is
an occupational money purchase scheme the scheme trustees
can buy an annuity on the members behalf.
Can a tax free lump sum portion be taken from the whole
pension fund?
It may not be possible to take the tax
free lump sum from the whole pension fund because
in many cases a personal pension contains protected rights
benefits. Tax free cash of 25% can only be taken from
the non-protected rights portion including any part of
the fund used to purchase dependents benefits, whereas
no tax free cash can be taken from protected
rights.
The exception are personal pensions taken out before 27
July 1989 where 25% can be taken from the pension fund
including protected rights, but excluding transfers in
from an occupational pension scheme and that portion of
the fund used to purchase a survivors
pension or dependants benefits. For anyone that has
a retirement annuity policy (RAPs)
it is possible to take tax free cash from the whole pension
fund.
Is a retirement income always guaranteed?
Once a pension annuity or purchased life annuity has been
bought the income is guaranteed for the life of the annuitant.
If this has been established as a joint
life annuity, the income will continue at the same
income level or as a reduced dependents or survivors pension
for the whole of the spouses life.
Further annuity
protection is offered by the Policyholder Protection
Act 1997 (PPA 97) in the event of the insurance company
becomes insolvent. In this case 90% of the income provided
is guaranteed.
If phased
retirement or pension drawdown has been opted for
by the individual, the residual pension fund is likely
to be invested in equities or fixed interest securities.
In this case the fund value can go down as well as up
so the future income is uncertain and could reduce. This
also applies to other options such as a unit-linked annuity
or open annuity.
Why is the annuity offered by my provider such poor
value compared to an open market option?
Providers of pension arrangements have a legal obligation
to offer an annuity to individuals at retirement, whether
they are in this market or not. There is also a compulsion
for people to buy an annuity with at least 75% of their
pension fund when they do retire and take their pension
fund.
As 2/3rds of people retiring buy the annuity offered by
the provider anyway, even if it is up to 30% less than
an open
market option from a competitor, pension fund providers
do not feel they need to offer good value for money.
How can an open market option offer
a higher pension income than my provider?
Some providers specialise in offering annuity products.
They could provide the whole range or specific types of
annuities such as a compulsory purchase annuity (pension
annuity), purchased life annuity and impaired or enhanced
annuity for both pension and life products.
The provider can use the annuity market to balance their
overall liabilities. For example, all policies involve
paying money out at some time in the future, whether they
are investments, endowments or life assurance. A disaster
at an industrial plant could mean a sudden claim of millions
against the providers life assurance if there are many
deaths. An annuity can provide a large amount of money
quickly with a relatively small cost in the short term.
Many providers only offer very competitive annuity rates
when they need to improve cashflow, as annuities can attract
tens of millions of pounds per month to a single insurance
company. This could occur if the provider has a large
number of maturing endowments and rather then sell investments
(possibly at the wrong time) to pay out the maturing claims,
improved annuity rates can attract the capital sum to
meet these obligations. This could mean offering good
rates for a single week only.
When an annuity is purchased the provider takes about
4% as a charge initially paying 1% to 1.35% to an intermediary,
thereby improving liquidity, and invests the balance.
Over time some annuitants die early and do not receive
their original capital returned as payments, thereby creating
a mortality profit for the insurance company. Some of
this is returned to future annuitants in the form of higher
annuity rates.
To find the providers that are offering the best rates
at any particular moment,individuals must seek an annuity
and pension bureau offering specialist
advice of an independent financial adviser (IFA)
that has the qualification K10 (retirement options).
Could my pension provider offer a competitive enhanced
or impaired life annuity?
It is unlikely that the existing pension provider can
offer a competitive enhanced or impaired
life annuity, if they offer one at all. As 2/3rds
of people at retirement accept the rate offered by the
provider without considering an open market option that
could add up to 30% more pension income to a standard
annuity, there is little incentive for the provider to
be competitive.
There are only a small number of life companies that offer
enhanced or impaired life terms and the only way to secure
the increased
income is to exercise the open
market option. In most cases it is possible to get
a free quote of the best annuity at that time and this
could increase the pension income substantially.
How ill do you have to be before receiving an enhanced
or impaired life annuity?
An individual aged 50 to 75 could be healthy now but due
to their lifestyle have a reduced life expectancy. For
example, they may have smoked 10 cigarettes per day for
the past ten years and could qualify for an enhanced
annuity.
May be the individual has been a manual worker most of
their working life or lived in a particular location and
this could mean they qualify for enhanced terms. For a
more serious illness what is important is how this reduces
the life expectancy of the individual, even if they can
get around and do things today. So for an impaired life
annuity the medical
conditions as well as the age are taken into account
by the underwriters.
Are there any disadvantages of waiting to take an annuity
until later?
An individual with a personal pension could leave the
money until they are aged 75 before having to buy an annuity,
if they do not need the income, or transfer to a pension
drawdown plan, take a tax free lump sum and a smaller
flexible income.
There are risks associated with doing this. The equity
markets could fall further and thereby erode the pension
fund value. The future
trend could be that the annuity rates will fall and
this would mean a lower income from the pension fund.
Also, by not buying an annuity the individual does not
benefit from the mortality profit. This means that mortality
drag impacts on a pension fund the investment return
must be greater, usually by 1% compound each year, in
order to match the income produced by an annuity.
If I don't want a conventional annuity income, are
there any other options?
This depends on the size of the pension fund on retirement.
Other options involve taking some risk and this means
a larger fund is required. For example, an individual
could transfer a fund, usually recommended to be £100,000
or more, to a pension
drawdown plan where a tax free lump sum can be taken
immediately. The balance can provide a variable income
between Inland Revenue set levels and the fund can be
invested in equities for growth.
Other options could be a with-profits
annuity or unit-linked annuity where the individual
chooses the income from the annuity. A with profits annuity
pays at a bonus rate which could go down if the income
level chosen is too high, but ultimately the income is
smoothed out over time. A unit-linked
annuity carry a much higher risk as they are dependent
on the performance of the equity market and the annuitant
should have other sources of income.
For those with £250,000 or more, an open
annuity can offer the greatest flexibility of income
for the individual and spouse while they are alive with
the opportunity to pass the residual pension fund to their
beneficiaries on their death. The underlying assets are
invested in equities so there is a higher risk with an
open annuity. However, due to the large initial investment,
an open annuity may be more attractive to people with
a self invested personal pensions (SIPPs)
plan.
If I buy an annuity and die shortly afterwards, will
there be any money for my beneficiaries?
For both a compulsory purchase annuity (or pension annuity)
and a purchased life annuity a survivors pension and dependents income
can be selected to provide an income for a spouse or children
under the age of 18 years.
However, if these options are not selected, then on the
death of the annuitant there can be no capital for the
beneficiaries. This results in a mortality
profit for the life company of which part of the profit
is used to improve annuity rates for future annuitants.
It is possible to buy an open
annuity where the beneficiaries can receive any residual
pension fund on the death of the annuitant but this would
require a minimum investment of £250,000, and therefore
out of reach for the majority of individuals.
Are annuity rates expected to rise in the future?
The expectation is that annuity rates will remain at their
current levels or fall in the future. This is because
of a number of economic factors. The rate of inflation
in the UK is now under control between the range of 1.5%
to 3.0% reducing the yields from investments and gilts
which are purchased by the insurance companies to pay
annuity income to annuitants.
The UK Government uses the gilt market to raise money
to increase public expenditure. It does this by offering
attractive rates of interest, but currently this money
is not required. The market expectation is that the UK
will eventually joint the Euro. As the interest rates
in Europe are lower than in the UK, this means that UK
interest rates must fall to match that of Europe.
Finally, in the past there was only a single annuity market
where the early death of an annuitant resulted in a mortality
profit for the other annuity holders. However, these annuitants
are now selecting against the insurance companies by opting
for an enhanced or impaired
life annuity, phased retirement or pension fund withdrawal.
This has the effect of reducing the mortality profit and
hence the annuity rates.
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