The great annuity debate and what it means for your pension

What’s the financial equivalent of a straightjacket? Some investors, a growing throng of industry professionals and now the new coalition government would say an annuity.

 

The issue of buying an annuity from your own pension fund is now up for debate after the Government proposed to scrap the current compulsory requirement in the latest budget, but what are the implications of this?  

 

Firstly, taking a brief look at the history of retirement planning is useful. Prior to 2006 every member of a defined contribution pension scheme that reached age 75, and had not purchased an annuity, had to purchase an annuity (after taking a tax-free pension commencement lump sum).  An annuity is a life policy that converts money from a pension fund into a secure  income for life. 

 

Dominic Baldwin from Xentum Wealth Management said: “Annuities are not perfect and the main criticism of them is that they are inflexible and are not open for negotiation. For example, the death benefits are usually limited to a spouse’s pension and/or a guaranteed period/value protection.  Another problem is that some individuals have had to buy an annuity at 75 when annuity rates have been low and/or after the stock market has fallen.”

 

The previous Conservative Government tried to address some of these issues in 1995 by introducing unsecured pension (USP), which allows an individual to draw an income from what’s left of their pension fund after taking out the initial lump sum – therefore deferring the purchase of an annuity until the age of 75. 

 

Dominic added: “The main attraction of USP is the ability to vary the income taken and the fact that the pension fund can potentially benefit from future investment growth.  In the event of death prior to age 75 the residual fund can usually be paid as a lump sum death benefit less a 35% tax charge. 

 

“However, in reality USP only provides temporary relief, as the vast majority of individuals in a USP currently live beyond 75 and are still caught out by the compulsory age 75 rule.” 

 

In 2006 the Labour Government introduced alternatively secured pension (ASP) so that individuals who vehemently objected to annuitisation did not have to purchase an annuity at the age of 75. 

 

Although ASP is based on the USP model, the income limits are more restrictive.  It was not intended to be a mainstream alternative to an annuity and the tax rules (including tax charges on the residual fund which can be as high as 82%) mean that most people continue to purchase an annuity at age 75.

 

So, what are the proposed new rules that will come into force on 6 April 2011?

 

  • No requirement to take benefits from a pension scheme at any age
  • ASP will be abolished and USP will be available beyond age 75
  • USP will be available in two formats: capped and flexible
  • A 55% tax charge will apply to lump sum death benefits paid from pensions in USP and to pensions where benefits have not been taken by age 75 

 

The Government has reiterated that the main aim of a pension scheme is to provide a replacement income in retirement and not to provide a vehicle for the accumulation of capital sums for the purposes of avoiding inheritance tax. 

 

To that end, the Coalition Government has said that inheritance tax will not ordinarily apply to unused pension funds, but it will monitor the situation to ensure that the system is not abused.

 

Dominic explains: “The new proposals are designed to give individuals more choice which is clearly a good thing.  It should be borne in mind that the increase in the tax charge applied to the USP lump sum death benefit prior to the age of 75 has to be balanced against the reduction in the tax charge applied after age 75. 

 

“It is also true that annuities will continue to meet the requirements of most individuals, for example those with small pension funds and who require the certainty of a defined income stream.  This is because annuities provide a guaranteed income and ensure that an annuitant will not run out of money during their retirement.”

 

 

Please note the material is for general information only and does not constitute investment, tax, legal or other form of advice. You should not rely on this information to make (or refrain from making) any decisions. Always obtain independent, professional advice for your own particular situation.