The starting point relates to your approach to risk. If you want to take no risk, you will need to buy an annuity. Options that can be included are a widow’s pension and minimum payment periods. You can arrange for the pension to increase in payment, either on fixed terms or in line with inflation. You can even choose to have your income paid monthly, quarterly or annually. Every one of these options costs more.
The annuity that will provide the highest level of income will be an annuity on your life only without any escalation. However, we must never forget how inflation erodes the value of money over time. Once you buy an annuity product, you are locked in for ever.
You can build an element of risk into an annuity product by choosing a level of income that is supported by a certain investment return. Investment-linked annuities carry a risk in that if the return on the investment backing the annuity is not as good as anticipated, the level of annuity can fall in value. The object of choosing an investment-linked annuity, however, is that investment returns will hopefully be better and the annuity will increase in future years.
New legislation has also given us the ability to provide for short-term annuities and for a capital sum payable on first death to be used to provide income for others in the future.
Then there are impaired life annuities. If your life expectancy is shorter than normal, the impaired life annuity market could provide a higher return. Enhanced annuities provide increased rates should you undertake activities that might reduce your life expectancy, such as smoking.
Annuities effectively provide certainty and, apart from investment-linked annuities, an absolute guarantee with no worries for the future. They appear expensive but you must bear in mind the period over which you hope to receive your income.
The alternative to buying an annuity is to draw down income from your pension fund. This was introduced in July 1995 and is now called unsecured pension.
In its simplest form, you retain your pension fund and draw down income from the fund. Here, of course, we are moving into areas of considerable risk. If the amount of income you draw down from the fund is more than the investment return on the fund and the charges to maintain the contract, then your fund will fall in value, as will your income.
If in this situation you continue to draw down your higher level of income, you will be in a downward spiral which will be very difficult to move out of.
However, one of the great advantages of income drawdown is that, should you die before age 75, the full value of your fund is available to your partner to continue taking an income or to take the full cash fund less a 35 per cent tax charge. The fund is also available to others, at your request, to take as a lump sum, less the 35 per cent tax charge.
If you are happy with the investment risk and that risk can be minimised, then income drawdown is an attractive contract. However, it is not for the faint-hearted or for those who need security in retirement.
Under current legislation, there is still the appalling situation that should you or your partner die after age 75 while in income drawdown, then the remaining fund could be liable to a combined tax charge amounting to 82 per cent. Both the Conservatives and the Liberal Democrats are committed to doing away with this rule.
As pension funds continue to increase and more people retire, the size of the overall market is increasing dramatically and contracts continue to develop.
There are several excellent annuity providers, usually the well known insurance companies. You also have insurers, such as Scottish Equitable, which are very keen to take more of the annuity market.
The impaired life market is very competitive, with some excellent small providers such as Just Retirement and Partnership Assurance.
Income drawdown has been correctly dominated by the self-invested pension market, generally with big funds and often under some form of discretionary investment mandate. However, several contracts entering the drawdown market aim to reduce the level of risk, notably Hartford’s, whereby certain guarantees can be provided with regards to income and capital values.
Once in an annuity, you cannot move to drawdown. However, in drawdown you always have the ability to use some or all of your money to buy an annuity.
Richard Jacobs is managing director of Richard Jacobs Pensions & Trustee Services