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Protect And survive

This year looks like being a defining year for annuities. It is clear from the Government&#39s statements that it has taken time to cut through the dross that surrounds the topic.

The need for greater visibility for the open market opt-ion was highlighted in the Red Book issued with the Chancellor&#39s autumn statement.

It also announced an annuities consultation document focused on improving pensioner choice, customer benefits and greater competition in the annuities market.

Whatever the outcome, the decisions made must address the needs of pensioners across the wealth spectrum and not just the needs of the wealthy, whose particular issues seem to have been the focus of the “debate” so far.

The Government must also ensure that the solutions adopted address the demographic shift that has transformed the nature of retirement in the UK.

The life expectancy for a man aged 60 is now 24 years. Four out of five men aged 60 will live beyond the age of 75 and one in four will live beyond 90. Remember that, on average, women live about three years longer than men.

The Government can make these changes from a position of some strength. First, it has a successful pre-funded pension savings regime which is the envy of its European colleagues who also face their own demographic timebombs, many armed only with their pay-as-you-go state pension schemes.

Second, it has helped create a climate of low inflation, which is good news for all pensioners and those on fixed incomes. It is a measure of the quality of the debate so far that this universal benefit has been largely ignored in favour of an obsession with low fixed-interest annuity rates.

The weakness that the Government and providers must overcome is the general ignorance of annuities and the issues that surround the new realities of retirement income in the UK.

Few fully recognise that it is sustainable income which is paramount. At retirement, many are preoccupied with early death benefits and pay little attention to the fact that once they are passed the age of 75, it will be the highest possible sustainable income that is and always was their big issue.

Few people know what an annuity is. It is a combined insurance and investment contract. The insurance is there to guarantee an income for life and manage the very real risk of running out of income.

The investment part of the contract can offer a wide choice of funds and fund managers, especially to those with bigger funds and suitable risk pro-files. Few realise that the oft repeated assertion that “annuity rates are lower that they were” applies only to annuities that invest in fixed-interest investments. Fewer still take low inflation into account when assessing the real value of this type of annuity.

The average pension fund at retirement is in the region of £25,000. The vast majority has not saved up enough to provide a comfortable retirement income.

It is for this reason that 80 per cent of annuities bought at retirement are on a level basis because of the relatively high income and security that this group usually needs.

Any nationally agreed solution must address the needs of this majority. Solutions which demand the purchase of inflation-proof annuities are unacceptably restrictive and will increase dissatisfaction with annuity rates.

As well as exacerbating the already scant supply of suitable asset-backing, the lower-starting incomes of RPI-linked annuities are likely to increase (rather than decrease) dependence on state benefits at the point of retirement, one of the costs that concerns the Government most.

What then of the vocal minority who has accumulated more pension savings than are needed for their retirement income needs and so, quite naturally, want to pass these savings on to their children?

An holistic view of personal wealth would help to put their retirement income needs into perspective. Wealth usually comes in three more or less equal pots – private savings (for example, Isas), domestic property and pension savings.

Managing the latter to provide their lifetime income can help keep intact their private savings and domestic property for inheritance purposes. After all, the statistics show that this group is more likely to survive to extreme old age than the general population and so have the greater need for sustainable income.

Having said this, any solution must address the income, investment and inheritance flexibility needs of the wealthier minority. The Government is clearly looking for further product innovation and already the new-generation flexible lifetime annuities offer income and investment choice but not as yet “return of fund” death benefits.

It is this vexed area of annuity death benefits that offers the opportunity for the most dramatic improvement in the customer appeal of annuities.

The current annuity rules are inflexible because they insist that death benefits are paid as income.

In the mid-1990s, an annuity with a 10-year guaranteed payment period would have guaranteed the return of the purchase price (live or die) to a typical 60or 65-year-old.

As a result of the decline in fixed-interest annuity rates in the late 1990s and, to a lesser extent, improvements in life expectancy, this is now no longer the case.

So, for most people retiring now, annuity death benefits represent poor value, regardless of size of their fund. The introduction of some form of commutation, perhaps capital protection, would help solve this problem.

Because of the relatively low cost of providing death benefits in the early years of an annuity, the cost of full capital protection is moderate. For example, for a 60-year-old man, adding capital protection to his annuity would reduce his income by about 1.7 per cent. At the age of 65, the figure is 3.1 per cent. Such an innovation would revolutionise the annuity market by removing at a stroke the main source of criticism.

Annuities would then be able to offer a death benefit option that did not result in the “loss of the fund”. This would mean that annuities could offer flexibility in the three key areas – income, investment and inheritance.

Freed from these distractions, the unique ability of annuities to provide the “maximum sustainable income” efficiently that so many need should at last shine through.

The Government&#39s res-ponse to David Curry&#39s recent private member&#39s bill also indicates that it is looking for greater flexibility and for cost-effective solutions and not just in terms of Revenue tax take.

The Government recognises that secure income is essential for a generation of pensioners living longer than ever before – not least for the 11 million or so in occupational pension schemes.

Annuities have an important role to play as cost-efficient generators of sustainable lifetime income.

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