From cradle to grave?

With the removal of compulsory annuitisation, for the first time advisers will be able to consider lifetime financial and investment planning within a pensions tax wrapper.

It will be 15 years in July since the first income drawdown products were launched in the UK following the Treasury’s reversal of the previous sacred cow of annuity compulsion. Annuity purchase had been seen as part of the pensions deal: the trade-off for the attractive tax reliefs enjoyed while accumulating pensions wealth. The change in thinking was in part a response to a large lobby from advisers who felt that annuity compulsion was simply unfair and inequitable.

Since then, we have had several consultation documents and proposals that have looked at whether the current drawdown rules need to be modified. The original rules worked well, but the problem was they did not help anyone aged over 75. In 2006, as part of the pensions ‘simplification’ changes, Alternatively Secured Pension was introduced for those over 75 and surprisingly, and in my view unnecessarily, the rules for drawdown (or Unsecured Pension as it was renamed)  were modified and in the case of tax-free cash relaxed.  Unfortunately, the ‘simplification’ has led to a much more complex regime with anomalies and inconsistencies in tax treatment of income and death benefits.

Government intentions

In its emergency Budget, the new Government announced its intention to “end the effective requirement to use a pension fund to buy an annuity by age 75, with effect from 2011-12”. Unfortunately, that is just about all it has said. It has introduced a temporary arrangement for those approaching age 75 by increasing the age by which an annuity must be purchased to 77, and has confirmed that anyone dying after 22 June and over the age of 75 will be subject to the USP death benefit rules, rather than the far more penal ASP regime. However, rather confusingly, it appears that it is still necessary to elect to take any tax-free cash by age 75. Also nothing has been said about those who elected for ASP before 22 June, probably a few thousand individuals.

Some have interpreted these changes to mean the Government is simply considering extending the age limit of 75 to a higher age of 80 or 85. I do not believe that. I think it really does intend to remove the requirement altogether. The Government plans to consult shortly on the detail of the changes to be introduced in 2011-12 so we may not have long to wait.

Clearly the implications of these changes may be significant, and present considerable challenges to advisers during this period of uncertainty. The Government also faces challenges in introducing a new regime that is fair, simple and durable, particularly as whatever it does must fit into the existing pensions tax regime, which it has also announced it plans to review.

For many – particularly those with smaller funds – say, less than £50,000 in total – an annuity is likely to continue to provide the ‘best’ retirement income solution, even though current annuity rates are at very low levels based on historical comparisons. What is more, competition among annuity suppliers for this business is limited, and it is likely that rates may worsen as a result of Solvency II. Should inflation return, the current annuity ‘deal’ will look even poorer,  even if longevity trends might suggest the opposite.

Failure to achieve best rate

The real issue with this segment (and they are the majority) is the high numbers of people who continue to fail to get the best available annuity rate. Despite many campaigns, even now only about one in three annuitants elects the Open Market Option, which is a pretty appalling state of affairs. Some good progress has been made by the Origo Options initiative in cutting processing times and by PICA in raising the profile of this issue, but there is a very long way to go before the industry can start to feel comfortable that most annuitants are getting the best and most appropriate annuity. It may be that some further legislation or regulation in this area will be required.

For those with larger funds (upwards of £50,000) there could be more options to consider. The main considerations are likely to be:

• Income needs: these are likely to vary during retirement both as result of changing expenditure patterns and other sources of income;
• Wealth preservation: rather more challenging under the current regime, not least because of the penal death benefit provisions that currently apply after age 75, particularly for those without dependants. There are potentially conflicting objectives of maximising income to reduce unused capital while minimising the risks of capital running out prematurely;
• Tax efficiency: again, a tricky issue because of the conflicting rates of tax, on income, capital and inheritance, and of course because of changing personal circumstances which may affect marginal tax rates;
• Life expectancy: the rates of improvement have been showing a consistent pattern for several years, and there are suggestions not only that this will continue but may increase. Clearly, personal health and family history will be big factors to take into account.

Cradle to grave solution

With the proposed legislative changes the prospect of a genuine cradle to grave retirement savings solution could become a reality. Much will depend on how far the Government is prepared to go in levelling out the tax treatment, particularly post age 75, and of course what happens to pensions tax relief pre-vesting.

Advising on retirement options is probably one of the most complex areas that advisers face. Although we may see some simplification post-2011, it promises to remain an area where the adviser will need both experience and knowledge.

Increasingly, and especially for wealthier investors, retirement is likely to be phased and the solutions are likely to involve a varying blend of products including drawdown and a range of annuities.  With the removal of a requirement to buy an annuity, for the first time advisers will be able to look at lifetime financial and investment planning within a pensions tax wrapper. This is to be welcomed and potentially offers advisers enormous opportunities.