I have a substantial fund held within various unvested personal pension arrangements with leading providers. As I have significant additional assets, I have not needed to use these funds but am now fast approaching my 75th birthday and understand that I will be forced to purchase an annuity. Can you please advise me on the options available.
As you correctly suggest, UK pension legislation dictates that funds must be used to secure retirement income, in the form of an annuity, by the policyholder's 75th birthday. Speculation exists that this rule may be amended but, alas, this is likely to come too late to affect your own decisions.
The basic concept of an annuity is that you exchange your capital, in the form of your pension fund, for a guarantee from an insurance company to pay you a particular level of income for the rest of your life, regardless of how long you live.
A cross-subsidy exists, whereby those who die early effectively subsidise ongoing payments to those who live beyond their expected mortality age.
Until fairly recently, the purchase of a conventional annuity was the only real choice. But the market has developed considerably in recent years and an ever increasing number of options has become available to the potential annuitant.
It is likely to be in your best interest to shop around to secure the best possible terms. Most pension policies allow you the option of transferring your fund to an alternative provider with better annuity rates. This facility is known as the open-market option.
It is also important to establish whether you would benefit from enhanced terms as a result of any medical conditions or whether or not you smoke. An impaired life annuity could potentially increase retirement income by up to 30 per cent.
There is a current perception that annuities offer poor value for money although upon closer analysis this is not necessarily correct. Annuity rates are at their lowest level for about 40 years. However, while rates have been falling in recent years, their buying power has not, as inflation levels have fallen more significantly.
If you had purchased an annuity in 1960 at age 75, you might have expected to live for another five years. Yet, according to current mortality tables, you are now more likely to live for at least 10 years. It could therefore be argued that annuities are somewhat better value than 40 years ago because you will receive your income over a much longer period.
Consideration will have to be given to the choice between a level annuity and one where the income increases each year. Although inflation is relatively low at the current time, over the long term it can have a seriously detrimental effect on your level of income. For example, with inflation at 2.5 per cent, the real value of your retirement income will be cut by 22 per cent over 10 years.
You also need to consider whether you would like to incorporate a pension for your wife, payable upon your death, and at what level this should be established. Further consideration must be given to the introduction of a guaranteed period, whereby the provider guarantees to pay the full pension income up to the end of the chosen guaranteed period – say, five years – even if you die before the end of that time.
All these alternatives can be incorporated, subject to varying levels of initial income and security.
The advantage of a conventional annuity is essentially the built-in guarantee of a lifetime income, regardless of any change in the prevailing economic environment. Therefore, for the client who is completely risk-averse and values their ability to receive a fixed level of income without risk, this option may prove to be attractive.
On the other hand, there is no real flexibility within such a contract and, once the annuity has been established, there is no opportunity to change the basis of the contract terms. For example, if you elect to incorporate a widow's benefit and your wife predeceases you, you will have effectively paid a significant premium for a benefit that will not be enjoyed.
Recent innovations include with-profits and unit-linked annuities which provide an income linked to the underlying investment performance of insurance company funds. As these funds are likely to invest in a range of real assets, including equities and property, the long-term returns are usually expected to be higher from those generally available from a conventional annuity. In theory, it is possible that if the fund delivers competitive investment returns, income may increase at a higher level than a conventional annuity.
Flexible/open annuities are an even more recent innovation and, theoretically, provide a greater degree of flexibility and choice for individuals with substantial pension assets who are reasonably comfortable with an additional level of risk.
As you will appreciate, the issue of purchasing an annuity before your 75th birthday is fairly complex and any final recommendations will be made on the basis of our subsequent meetings and our detailed understanding of your personal requirements, financial objectives and attitude to risk.