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The third dimension

More and more people are looking for alternative ways to take their pension benefits but how many consider the whole market before making a potentially irrevocable decision?

Rightly or wrongly, many people do not like annuities but an unsecured pension is only suitable for those who are comfortable taking on an element of risk. Many people want the guaranteed income of annuities, with the death benefits, inflation-proofing and flexibility associated with USP. Flexible, third-way annuities could help. In the US, 80 per cent of retirees use this type of product. So, are these products the panacea or are they a jack of all trades?

The third-way pension is usually structured in one of two ways:

  • Annuity – commonly structured as a fixed-term, value-protected annuity plan, typically running for five years at a time, with the option to include guarantees to protect maturity values or the income. Unlike a traditional lifetime annuity, these products tend to offer the ability to alter income levels between certain limits and allow the facility to provide a lump sum on death.
  • Unsecured income – option to apply a guarantee so that your fund value will never fall below your original investment. Some plans also allow all or a portion of any growth in the plan’s value to be locked in and a new minimum guaranteed level is then set. The option to select a guaranteed level of income is also commonly available.

The common theme is that they allow people to keep options open at the point of retirement while still guaranteeing some returns. One of the greatest fears of annuitants is dying early and “losing out”. Guarantees, spouses’ pensions and value protection can alleviate these concerns but all reduce the income available to the annuitant. USP provides more flexible death benefits and third-way products can do too. In addition to providing the death benefits available under annuity or USP (depending on the product), some also provide a guarantee to return the original investment amount on death, even if the fund value has dropped. Once bought, the terms of an annuity cannot be altered. For those whose spouse predeceases them, buying a spo-use’s annuity may be seen as money lost and if ill health sets in after the annuity is bought, the option of accessing enhanced rates is no longer available.

Third-way products allow you to defer making a fixed decision on what benefits are or are not required, meaning that you may have greater certainty at the time that you eventually make the choice. The delay in buying could mean that you get a higher rate when you finally buy an annuity but this may not always be the case.

Annuities provide certainty of income for life. Third-way products can provide this too, with the ability to vary the income that you take, which is not possible under a traditional annuity.

They also offer the potential for an increasing income if investment returns are favourable. This helps counter what is potentially the greatest problem facing those with traditional annuities – the effects of inflation on the purchasing power of their income. A person retiring in their fifties could have three, four or more decades to live. Over such protracted periods, even a modest inflation rate can have devastating effects on an annuity’s purchasing power.

Annuities are easy to understand and incur no ongoing costs from the provider and require no reviews, meaning advice costs are low.

USP is more complex and is generally more expensive to set up and run. Third-way products are also more complicated than annuities and as expensive to set up as USP. They also require regular reviews to ensure that they remain suitable for the client, so the servicing costs are high.

On top of this are the costs of the guarantees, which can be as high as 1.6 per cent a year. The Hartford pulled out of the UK market largely due to increasing costs of the guarantees and rivals Aegon and Met Life have had to increase the costs of the guarantees to new investors. Many, notably Fidelity, have questioned the value of the guarantees above providing peace of mind.

In order to meet the challenges of longevity, we will have to embrace a combination of working longer, saving more and being more creative with our retirement pots. Therefore, third-way products will have a space in the UK market but only time will tell if they can become as popular as they are in the US and Japan.

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