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Seamless strategies

Let us examine the problem areas of the age 75 rule for annuity purchase in chronological order of investment, income during life and inheritance on death.

It is estimated that four out of five men now aged 60 will live beyond 75. If investment was important prior to retirement, it will be equally important during retirement. Many will draw their pensions for longer than they saved for them so it would help if a long-term strategy could be adopted and followed through retirement.

For those with an appropriate fund size and attitude to risk, unit-linked investment in retirement has lots of attractions. Most will want to take advantage of higher-yielding equities as they set off into retirement. Many will then move gradually into less volatile assets as they grow older and become more risk-averse. A unit-linked investment environment enables the investor to control this transition.

Until now, moving between the various pension regimes has made investment continuity difficult, if not impossible. But what if personal pension, income drawdown and pension annuity contracts shared the same investment environment and choices? Investors could then move between them without having to disinvest each time. Seamless investment could be enjoyed for potentially a 40-year uninterrupted period.

Many in personal pension and/or drawdown contracts switch out of equities into bonds as annuity purchase approaches. This is because conventional annuity purchase is envisaged, so protection is needed against market volatility at the point of annuitisation. But this switching of assets comes at a price. If a systematic programme of switches is carried over the 10 years leading to annuitisation, then, on reasonable assumptions, the fund could be reduced by over 10 per cent in the process.

For many, the transition from drawdown to annuity will require careful thought, not least for those whose need for the superior death benefits of drawdown is paramount, where the move may be delayed to close to their 75th birthday. For others, maximising their lifetime income will have become the main objective by this stage of life.

A seamless transition from drawdown to annuity opens up the possibility of taking better advantage of both these contracts. Many may prefer drawdown in the early years of retirement, when death might cause loss of funds, followed by annuitisation in the later years, when mortality cross-subsidy becomes more significant. The two complement each other. As the proportion of bonds in the portfolio increases, the yield might be expected to decline. However, once annuitised, the mortality cross-subsidy grows rapidly. For most men in their early 70s, the mortality cross-subsidy can be equivalent to an extra 2 or 3 per cent annual return. Therefore, there is a window of opportunity for those seeking to maximise their lifetime income by annuitising at the optimum time.

Drawdown allows retirees to withdraw variable amounts of income between set annual limits that are reviewed every three years. This facility was introduced to annuities in 2001 when the new generation of flexible lifetime annuities became available. These unit-linked annuities also enable retirees to withdraw variable income, be it between slightly different limits that are again subject to three-yearly reviews. In effect, this seamless transition from drawdown to annuity not only extends to investments but also to income flexibility, too.

What about death benefits? Personal pensions offer a return of the fund and drawdown offers a variety of choices, including a return of the fund less a 35 per cent tax charge. However, on the death of an annuitant, unless a joint-life basis has been selected at outset, death cover is limited to the first 10 years from the date of purchase. Nevertheless, a man approaching 75 can guarantee the return of slightly more than his purchase money by including a 10-year guaranteed payment period in a conventional level annuity. Crucially, these death benefits must be paid as income over the balance of the selected guaranteed payment period and not as a lump sum.

For flexible lifetime annuities, this means that up to 80 per cent of the fund can be protected for a further 10 years. This would give those annuitising near age 75, for whom death benefits remain the predominant factor, considerable death cover up to 85. But this remains an area where annuities can be improved although this requires a change in the regulations. This is why the lobby for the introduction of a money-back guarantee has been so strong in recent months.

The Government is interested in improving annuities for most investors. The option of a money-back guarantee would benefit all annuitants and address the main consumer concern about annuities head-on. In the event of death, where the total of annuity payments received were less than the original purchase money, the balance would be paid to the deceased&#39s estate as a taxable lump sum. ABI research has found that this option would be popular and the cost would not be prohibitive. Estimates suggest it would cost about 2 per cent more than the current 10-year payment guarantee period.

Innovative solutions need to be deployed to meet the needs of long-term retirement. For those with adequate funds and appropriate risk profiles, the seamless transition from unit-linked drawdown to unit-linked annuity can take much of the sting out of compulsory annuity purchase. Such a strategy is available now and takes full advantage of current legislation. But the money-back guarantee requires adjustments to legislation before annuitants can be sure their pension savings will be returned in one way or another, whether they enjoy a long life or die early.

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