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All the fund of the fair

Recent articles on the subject of the scandal of compulsory annuities, by Prudential Annuities and IFAs who specialise in annuity sales, would have us believe that compulsory annuities bought from pension monies offer good value.

Readers who believe this might also think turkeys enjoy Christmas. Fortunately, the press and people like Dr Oonagh McDonald are not being taken in.

Some 35 years ago, I was arranging compulsory annuities for clients at Noble Lowndes. At the time, a 65-year-old male could expect to receive £1,400 a year for each £10,000 of purchase money. The same sum today would get him an annuity of not much more than half this figure.

Readers might retort, “Ah, but what were interest rates or the return of gilts in those days?” Offhand, I can&#39t recall but I do remember that we simultaneously offered a full-term fixed-rate mortgage via the English Insurance Company at only 3.6 per cent a year interest.

Annuity rates aside, there is a much more fundamental reason why compulsory annuities are a complete scandal. The 1956 Finance Act recognised that as there is no return on death, all annuity payments must consist of a part return of your capital, plus interest on top. From that date, the capital element of an annuity bought voluntarily (a purchased life annuity) was not taxed.

However, this logical tax treatment was never extended to include compulsory annuities. The two types of annuity are, of course, identical. But successive governments did not wish to forego the extra tax revenue, in particular as they had the public over a barrel with the purchase of compulsory annuities.

A 65-year-old buying a level annuity voluntarily would currently receive, say, £8,500 per annum on a £100,000 purchase price. The capital element of this (that is, non-taxable) is £5,600 a year, so only the excess of £2,900 a year is taxable. The same chap buying a compulsory annuity (that is from pension money) would also receive about £8,500 a year and be taxed on the whole lot.

This means that the much acclaimed benefit of tax relief on pension contributions is at best no more than a tax deferral. In fact, now this Government has introduced tax on dividends within the insurance company&#39s pension funds, this means part of the fund will,in effect, be taxed twice.

Given this scenario, quite why the Treasury expects the public to flock to buy stakeholder pensions is beyond me. Unless they are given complete investment freedom at retirement and employer contributions become mandatory, it will not occur – nor should it.

If the anomaly in tax treatment between the two types of annuity was corrected, then I believe the purchase of annuities with pension money would be an attractive option – at least for those without dependants. Anyone with a spouse or beneficiaries to consider would not touch an annuity at any cost.

My cousin in the US has just retired and received his full pension fund as a lump sum, part of which was first taxed at his average rate of tax. A similar flexible pension regime applies in most civilised countries and there is nothing to indicate that retirees promptly blow the lot on riotous living or make dubious investments, hence losing their capital and ending up being supported by the state.

This is often cited as the reason we in the UK are forced to convert our pension savings into an annuity at retirement. I find this argument patronising to say the least. After all, someone who has been sensible enough to put money aside voluntarily into a pension plan over their lifetime (and take the investment risk throughout) is hardly likely to squander it all at retirement.

A recent article in Money Marketing speculated that due to clients&#39 increased life expectancy, only an annuity could provide a secure income in retirement and that alternative investments would run out prior to death. I would argue the very opposite, as the vast majority of annuities purchased are of a non-increasing nature. This is not surprising, as the starting income for an annuity which escalates, even by a measly 3 per cent a year, is approximately 25 per cent lower than its level cousin.

A person now aged 65 buying a level annuity is guaranteed to see the purchasing power of his or her “income” severely eroded by inflation over 10 years and to be almost worthless by 85, being average life expectancy. On the other hand, if a retiree were free to invest their ex-personal pension funds in real assets, their situation should be vastly improved.

For example, 8 to 10 per cent rental income plus capital growth is not unusual from residential property lets. For those who prefer collective investments, there are commercial property based unit trusts yielding 6 per cent gross dividend income, plus a history of providing rising income and capital growth. I am just quoting one of the many types of available investments, which might be suitable for pension money.

Many trusts pay out a high lifetime income to beneficiaries and also provide capital growth to the remaindermen. They have to invest to achieve this without eroding the capital and so could individuals with their ex-pension money – given half a chance.

The simplest answer to the annuity problem would be for this Government simply to extend the upper age limit for the option of income drawdown from 75 to 85 and also to recognise the tax-free capital content for those who prefer annuities. However, while income drawdown is better than nothing, it still unfairly restricts individuals on how they invest their own money in retirement.

The press has speculated that this infringement to your freedom of choice could successfully be challenged in the European courts. Whether true or not, one thing is certain – insurance company charges on income drawdown are currently so high that retirees&#39 capital is at risk long-term.

There are at least two methods I have come across for extracting the bulk of your capital from personal pensions. One is via the auction of a compulsory annuity, once purchased. They cannot be assigned so a separate legal contract has to be drawn up between purchaser and seller.

The second involves the IFA repeatedly moving the client&#39s pension transfer value between the cash funds of different product providers. On each transfer the IFA rebates the client, say, 5 per cent of the 6 per cent commission.

The Pension Schemes Office Updates 33 and 64 discourage commission rebating for pension business and set out that, if discovered, it could jeopardise approval of the scheme and incur a tax charge on the remaining transfer value. But in this case there is no transfer value remaining to be taxed after a year or so.

I only mention the above practices, which I do not support, because it illustrates the need for change to such antiquated and unfair rules. I hope this Government will grasp the nettle. In the meantime, all financial advisers should encourage pension clients to join Cappa (Compulsory Annuity Purchase Protest Alliance).


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