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Stewart Ritchie on pensions

Most of the attention on post-retirement changes from A-day has focused on income withdrawal and Alternatively Secured Pensions, but the changes to annuities merit serious consideration. The Inland Revenue plan to change the way annuities will work in the new pensions tax simplification regime after April 6 2006. The primary legislation for these changes is in Finance Act 2005.

A welcome change is that annuity payments can go down. When pension tax simplification was first announced, annuity flexibility was claimed as one of its merits. But in Finance Act 2004 annuities were not allowed to go down. However, Finance Act 2005 corrects this.

We still await regulations under Finance Act 2005 before we will know how much freedom we will have to innovate with annuity design but, for example, it would be nice to have a u-shape. This could reflect the need for a high income early in retirement when most active, a smaller need as activity declines with age, and an increased need in later old age to pay for care. Another example would be where a couple are retiring now, but the pension of one of them will not come on stream for a few years. It would be nice if the annuity of the other could start higher, but reduce when the second pension starts.

A reduction in annuity flexibility is the additional restriction that the member’s pension must be no smaller than any dependant’s reversionary pension. This is unfortunate, but to see why the Inland Revenue would want such a restriction, consider someone already at the lifetime allowance who is trying to get more pension for himself. He has a wife, but is not interested in giving her a good pension. So he says to her “I will put 500,000 into a pension pot for you, provided you buy a pension where the spouse’s reversionary pension (for me) is ten times your own pension”. This would be particularly useful to him if his wife was in poor health, or was likely to have an accident shortly after this lop-sided annuity was purchased.

The Revenue’s decision to allow transfer between life offices of annuities in payment has caused some excitement. However, consider the following scenario. An annuitant has just been told by her doctor that she has a year to live. Her financial adviser recommends she surrenders her annuity with Office A and reapply it on impaired life annuity rates with Office B. If such a surrender were allowed based on average life expectancy there would be a huge mortality option being exercised against Office A. It is one thing to say that the law will allow something but it is another to say that the life office will be prepared to vary the existing annuity contract. If it is prepared to do so, don’t be surprised if it asks for evidence of health.

Another relaxation is the removal of the need for schemes with less than 50 members to buy annuities when a member retires. If a pension is paid out of a scheme’s own resources, instead of an annuity, it runs longevity and in-vestment risks. Consider a situation where the managing director’s pot is half the total fund and he starts his pension in the scheme but without an annuity being purchased. The chances of the scheme’s solvency going pear-shaped are high, but the Revenue may argue that is an issue for the trustees and their advisers, not the tax authorities.

Finally, one of the annuity provisions which has not changed is the introduction of short term annuities. I hope these are a flop because I can’t think of a situation where they would be best advice. They may appear to defer the annuity purchase decision for the main pot but mortality drag and investment risk are ever-present. Governments should set the rules, and leave product design to the market.

Stewart Ritchie is director of pensions development at Scottish Equitable


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