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Insurance against living too long

Why do some commentators object to the compulsory purchase annuity regime?

The reason apparently is that annuities give bad value for money. In

arriving at this conclusion, they cite annuity rates today compared with

years ago. They also argue that annuities are unpopular because they do not

allow money to be paid to survivors on death.

In fact, figures produced by the DSS comparing the retirement income

generated by people retiring at different dates based on the same patterns

of spending before retirement show that, in general, those retiring in more

recent years have seen higher incomes in retirement than their predecessors

(source: The Changing Welfare State: Pension Incomes, March 2000).

The main reason for this is the historical good returns on equity

investments. Although the annuity rate purchased by a retirement fund is

lower than in the past, the same contributions paid in will have provided a

bigger fund with which to buy an annuity. The higher returns have more than

offset the fall in annuity rates, so those retiring in more recent years

have not been put at a disadvantage.

Two other relevant factors are the effect of inflation on the annuity and

life expectancy. In the 1980s, inflation was above 7 per cent compared with

below 4 per cent in the 1990s and around 2.5 per cent today. So inflation

should currently erode annuities at about one-third of the rate at which

erosion took place in the 1980s.

The impact of improved life expectancy is significant. In 1984,

60-year-old males could expect to live to age 77. In 1998, they could

expect to live to 79. This longevity risk is often ignored in the debate

about replacing annuities and giving individuals more freedom over how to

secure their income in retirement.

The cause of the longevity risk is that an individual may outlive his

assets. People will either spend their money too quickly and have

insufficient means of support at the end of their life when, typically,

costs can increase, for example, for nursing care, or not spend enough and

so not obtain maximum benefit from their retirement savings.

An annuity which converts a lump sum into a guaranteed income stream for

life solves this dilemma.

The fact that an annuity stops when the annuitant dies (subject to any

guaranteed period that may be built into the annuity) is often seen as a

flaw that could be avoided if more freedom were introduced into the system.

But where individuals have a strong desire to make bequests, the tax-free

lump sum could be gifted or other pre-retirement savings or life insurance

policies could be arranged.

In addition, an annuity helps to ensure that other assets, such as the

home, are not run down or sold if the individual lives longer than expected.

The Retirement Income Reform Campaign proposes changes to the current

system that would allow the individual to continue to take a taxfree lump

sum but they would have to buy an index-linked annuity at retirement to

meet the minimum retirement income, which would be set at about £140 a

week. This would include the basic state pension that stands at around

£70 a week. Above this level, there would be no need to buy an

annuity, so the current age limit of 75 when an annuity has to be purchased

would disappear.

The cost of an index-linked annuity of £70 a week would be around

£55,000 for a 65-year-old man and £62,000 for 65-year-old woman.

This flexibility, which has some merit, would give more choice for some

consumers but would not affect the vast majority.

According to Association of British Insurers&#39 statistics, the average

pension fund on retirement is between £25,000 and £30,000. This

is barely enough to buy a basic guaranteed income, let alone enough to

invest on the stockmarket where returns will inevitably be more volatile

and too risky for most people.

The annuity market has seen much product innovation in recent years such

as impaired-life annuities, with-profits annuities and income drawdown

plans but more is needed. An obvious one is an annuity that increases

should the annuitant suffer from ill health later in retirement. Such a contract was available many years ago but was withdrawn when the Inland Revenue la

ter judged that it did not fall within the pension tax regime.

A change in legislation to allow such a comeback would be welcome. But

even without this relaxation, the annuity market is healthy and gives good

value.

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Case study: administration — managing group life schemes

Our client leads the global market in high-tech electronics manufacturing and digital media. The trustees of the company’s final salary pension scheme insure death-in-service lump sum and dependants’ pension death benefits for active employees, as well as dependants’ pension benefits for deferred members (those who have left service).

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