The dictionary defines panacea as ‘a remedy for all ills’ and without doubt the retirement income market can certainly be described as not being in as rude a health as it has been in the past.
Government Actuary’s Department rates have hit the stops at 2 per cent and with annuity rates also touching all time lows, the income able to be derived from an individual’s retirement fund is now much lower than past expectations and may not meet projections from even a few years ago.
Scheme pension has been increasingly touted as a panacea, offering relief from the lower income options available at vesting, or indeed to those already in capped drawdown facing cutbacks at their formal review dates.
However, as with all non mainstream financial products, scheme pension must be fully understood by the adviser and the client. Not unlike an annuity, once accepted there is no room to move and no backing out.
Historically scheme pension was used primarily by large schemes. The level of income for the membership was set by the scheme actuary taking a view of the total pensioner membership age and also the expected return able to be achieved on average in the future, based upon the scheme assets and investment strategy.
A key feature was that control of the investment and capital of the fund backing members’ benefits remained with the trustees and this remains one of the reasons that scheme pension has increased in its popularity within money purchase schemes, especially small self-administered schemes and self invested personal pensions.
Key to understanding scheme pension is the fact that in accepting it within a money purchase scheme, the member gives up their rights to the capital sum accrued for them in lieu of a fixed income for life.
An early favoured use of individual scheme pension was for those members who were in poor health. Member specific underwriting would take place and in view of the reduced mortality, and thus fewer years of anticipated payment, a larger initial pension could be provided.
This could be improved further by the inclusion of a guaranteed minimum pension period of ten years. Such a guarantee allows the continuation of the annual payments when the member dies, to other beneficiaries.
In exceptional circumstances of severe ill health, where the actuary considers mortality to be less than ten years, a ten year term certain pension may be put in place designed to pay out the whole member fund, including expected future growth within the ten year period.
This situation has the fortuitous circumstance that as tax deducted on the continuing pension payments after death is only at the income tax rate of the recipient, the tax rate on distribution must, therefore, be lower than the blanket 55 per cent applicable to remaining funds on death whilst in capped drawdown.
In recent months though, this has not been the main driver behind the recommendation for the use of scheme pension. Instead, the higher levels of initial pension that can be provided have been the main attraction.
Where current GAD rates or standard annuities would provide a starting level of income for a 65 year old male individual with a fund of £200,000 of approximately £10,600 p.a. and £11,700 p.a. respectively (figures from the Money Advice Service Sep 2012), an actuary may take a view for scheme pension with regard to the individual’s health, or to the expected investment return.
As an example, a mortality uplift of five years might result in an increase to the starting level of pension of around 17 per cent. Or an increase in the expected return of the fund of 2 per cent p.a. could increase the starting pension by 25 per cent.
Such initial income improvements have become a popular, if perhaps miss-used, marketing aid.
The full ramifications of entering scheme pension need to be thoroughly understood as does the need to make the actuary’s assumptions as realistic, and not opportunistic, as possible.
Firstly, there are the health considerations. Using a higher rated age, which is not borne out by the members mortality, will result in funds running out before death. Not an enviable position for an adviser to explain to his client.
Secondly, an overly optimistic fund return which is not delivered will again result in either funds running out, or a reduction in pension level at subsequent reviews; hardly a matter of delivering on expectation to the client.
For this reason the actuary will need to work closely with the adviser and understand not just current assets held, backing the initial starting pension but how they might be adjusted over time in line with member attitude toward risk.
This intimate knowledge exchange will most likely not come cheaply, nor will the recommended regular reviews of income, a factor which might have a material effect on smaller funds, as might the ongoing adviser fees under RDR.
A large reduction in scheme pension might also incur the interest of HMRC, who of course expect it to be payable for life. Where it might be deemed that inappropriate assumptions have been used, perhaps to accelerate pension receipt above capped drawdown or annuity levels, they have the power to disallow any scheme pension payments, on which unauthorised payment tax charges might then apply.
Further, unlike capped drawdown where positive investment performance can lead to increased levels of income, with scheme pension, increases in pension are restricted and exceeding them may result additional benefit crystallisation tax charges applying.
In summary, where used correctly scheme pension may provide a solution to certain ills, but it is not a cure for them all.
Martin Tilley is director of technical services at Dentons Pension Management