The recent Budget confirmed the Government’s decision to revert to a maximum income drawdown limit of 120 per cent of theamount of annuity that could be provided using the Government Actuary’s Department’s annuity rate applicable for the member at the time they take benefits.
The Government had previously reduced the maximum from 120 per cent to 100 per cent from April 2011, to deter pensioners from depleting their funds too quickly and risk falling back on the State.
The reduction occurred at a time of challenging investment growth, worsening annuity rates and historically low gilt yields. As a result, some individuals experienced significant income reductions in the order of 50 per cent, leading to a public outcry and subsequently the reintroduction of the 120 per cent limit.
For individuals who suffered reductions of this magnitude, an uplift of 20 per cent will only partly improve matters.
Unless the proposed legislation is amended, the improvement will not be an immediate panacea, as the uplift can only be applied from the start of the pension year that falls on or after 26 March 2013.
The Budget also announced that GAD rates will be reviewed to ensure they are aligned with the annuity market.
This might mean a slight improvement if a blend of gilt rate and corporate bond yields can be used. However, the likelihood is for a worsening of the rate due to adoption of a true gender neutral rate rather than the current temporary measure of using the male GAD rate for both genders.
Despite the u-turn on the 120 per cent there is no indication that the Government has rationalised its fear of pensioners falling back on the state.
The continued alignment to annuities, the income from which must be payable for life, means that drawdown income must also be payable for life. This results in there ordinarily being funds left over following death, which would suffer a 55 per cent tax charge if passed as a lump sum to beneficiaries.
Although drawdown’s alignment to annuities has served a sector of the market well since its introduction in 1995, it is questionable as to whether adhering to such alignment makes drawdown fit for the purposes of today’s and future generations of retirees.
There is a need for compromise between the Government’s desire to protect against pensioners falling back on the state and giving individuals greater flexibility over access to income. But failure to compromise could result in more people shunning pensions in favour of Isas for retirement planning, which give zero protection for the Government against individuals falling back on the state.
To be fair, the Government did make an attempt to improve matters through the introduction of flexible drawdown but the reality is that few have taken this option, either because they do not have sufficient funds to secure the minimum income requirement of £20,000, or are not prepared to sacrifice a large proportion of their fund to annuity purchase in order to secure it. Annuity purchase is, after all, what they wish to avoid.
The annuity market has changed and continues to develop. Impaired life or enhanced annuities are now often used, with a move towards annuities becoming individually underwritten resulting in higher income levels for those with lower life expectancy. This contrasts with GAD rates that are based on average life expectancy.
Due to increased longevity, the benefits of annuity mortality cross-subsidy only begin to take effect from approximately age 75 onwards, which, when coupled with the inflexibility of annuities, makes the decision to purchase an annuity for a healthy individual before age 75 more questionable.
For someone entering retirement at say age 65 in good health there is a prospect of living for a further 20 years, and this can equate to a long term investment. As such, general investment principles would suggest exposure to equities for the prospect of real growth over inflation. Whilst the underlying drawdown fund can invest in a wide range of assets the GAD rate is pegged to gilt rates and therefore is not representative.
There is the real prospect in a shift from complete retirement on reaching, say, state pension age, to retirement becoming a phased process over perhaps a decade, as individuals continue to work beyond state pension age, supplementing earned income with pension income. The inflexibility of annuities does not suit them for use in this transitional period.
This leads to a conclusion that annuities and drawdown are two very different products and therefore drawdown should be governed by its own set of principles rather than being aligned to annuities.
Whilst a degree of controlled withdrawal should be retained, more credence should be given to those individuals applying prudence and moderating their income, as few of us want to be in a position that we have to fall back on the state.
Unfortunately current drawdown rules do not encourage prudence, nor aid flexibility. A few changes could improve matters.
Currently, if an individual does not use the full maximum income allowance, i.e. 120 per cent, within the pension year. A rule change should allow unused drawdown limits to be carried forward for up to three years within the triennial review period. For example if only 80 per cent income were taken in year one then in year two the balance of 40 per cent plus 120 per cent in year two could be taken.
Currently there is a 55 per cent tax charge on lump sum death benefits paid from remaining drawdown funds. A rule change should allow funds on death to be passed tax-free to beneficiaries’ pension arrangements.
Further rule changes could include:
Allowing realistic growth rate assumptions applicable to the drawdown investment portfolio, rather than imposing unrepresentative gilt rates.
An option for the maximum drawdown income to be set by actual life expectancy.
The move back to 120 per cent GAD will be welcome relief for some individuals in drawdown, but it is hoped that this is just an interim measure ahead of a fundamental review of drawdown for a longer term solution.
Robert Graves is head of pensions technical services at Rowanmoor Group plc