Picking the right avenue

Mike Morrison goes through the different avenues available to clients when it comes to taking retirement income

We are in the middle of very difficult economic times, combined with the onset of the 'baby boomer' generation reaching the age at which they can draw their pensions. It is hardly surprising then, that retirement is a hot topic and becoming increasingly complex. However, in spite of the markets, people will continue to retire. I am sure, though, that in some cases, imminent retirement might have had to be postponed for the time being.

There are a number of options available from pension schemes, all of which will be affected in one way or another by the economy and have their own advantages and disadvantages.

Annuity purchase

Until 1995 annuity purchase was the only real opportunity of converting a pension fund into an income stream.

Increasing longevity and falling interest rates have meant that annuity rates have steadily fallen and the general feeling is that they are uncompetitive.

They do, however, provide absolute security and the level of income bought will be paid for life. Towards the end of 2008, annuity prices did look more competitive than they have for a long time, but during 2009 they have started to fall once again.

Most annuities sold are level annuities with no inflation proofing to gain the highest starting level. This might not be a problem at the moment with the headline rate of inflation falling and longevity as it is, there could be time for several inflation cycles during someone's retirement.

The current historically low level of interest rates and volatile stock markets might also encourage annuity purchase as retirees are unable to get the required returns on their investments and decide to take the safe route and annuitise. This could also include people who started with an unsecured pension.

Unsecured pension (USP)

Until A-Day in 2006, this option was known more commonly as income drawdown. It was introduced in 1995 and allowed an income to be taken from a pension fund leaving the rest invested. Until this date, annuity purchase was the only real option. Some of the key issues that come into play in the current climate include:

- there is no need to take an income each year

- a member can, subject to the rules of the scheme concerned, vary the amounts taken each year within the specified limits

- the maximum income must be reviewed every five years or more frequently at the direction of the member and consent of the administrator

- there is a lump sum death benefit available among other options.

While not having the certainty of an annuity, the key elements of USP have been flexibility of income and the availability of a death benefit.

First and foremost, USP is an investment contract in that the funds that remain invested need to produce returns for the future, and in the current markets this could be difficult.

In some ways, the USP market has polarised. At one end of the spectrum is the traditional USP client, who perhaps with a fund in excess of £300,000, has other, additional wealth and who is prepared to dip in and out of it for income as and when required for ad hoc income payments.

At the other end of the scale, we are now seeing USP much more commonly used by people with funds of less than £200,000, who have got few other assets and need the maximum income they can get. This type of client does not want the inflexibility of an annuity, which would possibly suit them best, but they cannot afford to lose money. In such cases, I think that the investment issue is very different and maintaining purchasing power while aiming to keep the original capital is the order of the day.

With it harder to find investment performance, it should mean that fewer people go in to USP. Income drawdown does not work itself - there needs to be some correlation between the level of income needed and the critical yield with the investments that are being used. If individuals are not prepared to take the requisite level of risk then perhaps the advice should be for them to buy an annuity.

Many USP clients will have suffered a real 'double whammy' as their fund value will have fallen quite dramatically at the same time as the necessary Government Actuary's Department (GAD) rates. In February 2009 the gilt rate for calculating GAD reached its lowest ever at 3.75. The conundrum for such clients, particularly if they have a review date coming up, is when to lock in for another five years.

Alternatively secured pension (ASP)

ASP, in effect, is a continuation of drawdown past the age of 75 and therefore much of what has been said about USP applies in this case too.

With difficult investment markets, it might be that more people who are currently using ASP buy an annuity with a view to purchasing piece of mind.

Scheme pension

The final option is that of a scheme pension which, post A-Day, can be paid from any type of pension arrangement. In effect the scheme ring-fences an individual's pension fund and an actuary calculates the pension according to the age and health of that individual.

The actuarial assumptions are therefore important and any fund used to produce a scheme pension is likely to be reviewed every three years.

If the fund cannot sustain the level of a scheme pension, then it is likely to be reviewed in the future.

These are the main retirement options available, but there are also new ones such as 'third way' products. Again, the issue might well be with regard to locking in a guarantee at a time when the markets are low.

There is always likely to be a need for retirement advice and this is even more important if investment conditions are difficult.