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A European dichotomy

The current sources of retirement income for UK pensioners in aggregate are set out in the charts below. State benefits are the largest source of retirement income followed by private pensions (occupational and personal). The balance of retirement income is largely made up of income from investments and from work. Single pensioners appear to be rather more reliant on state benefits and less on private sources of incomes, but this difference may in part reflect a relatively large proportion of women and those of older ages among single pensioners. The lowest 20% of pensioners rely very largely on state benefits. Those with the highest incomes not only have relatively large proportions of pension and investment income, but also derive relatively large shares of their income from work.
Current forms: Income from the state and from occupational pension schemes is largely in annuitised form – a stream of income payable for the life of the pensioner (and in many cases their spouses or partners). Most (80% or more) of the private pension income shown in the charts derives from occupational pension schemes. The remaining pension income relates to personal pensions, where proceeds can be taken between 50 and 75 in the following form:
q Lump sum (maximum 25% of account);
q Annuity and/or phased withdrawal (balance of account).
‘Phased withdrawals’ (also known as drawdown) allow withdrawals to be made from the pension fund between a maximum and minimum rate each year. The pensioner carries both investment and survival risks. Under current rules the residual fund from phased withdrawals must be applied to buy an annuity by no later than age 75.
About 80% of total funds emerging from personal pensions is applied to buy annuities and the remainder, typically larger cases, to provide phased withdrawals. Average fund size for phased withdrawals is about five times that for annuity purchase.
Annuities can have a variety of structures (level or increasing, fixed or indexed or investment linked, single or joint life, with or without a death benefit) and the pensioner can select their preferred options (unless the funds have arisen from contracting out of the state second pension). In practice and understandably as the average annuity is only of the order of £100 (e145) per month, selections tend to focus on maximising initial income (single life, level income). The volume of annuities sold each year now exceeds e10 bn. Standard guaranteed annuities are rated on age and gender and rates tend to track movements in long term interest rates quite closely.
A recent development is for some companies to offer ‘impaired life’ annuities. In addition to age and gender, impaired life rates reflect characteristics of the annuitant such as health, smoking, location and occupation which would tend to identify those who as a consequence of poorer life expectations, can be offered enhanced rates of annuity.
Pension reforms: In April 2006 a new pension ‘simplification’ regime is due to be introduced consolidating a patchwork quilt of previous regimes. This regime comes at a time when a large number of defined benefit schemes have in recent years been closed to new entrants and replaced by defined contribution (DC) schemes.
There has been a tendency for such scheme closures to be accompanied by a reduction in employer contributions and by implication shrinkage of prospective pensions. The simplification regime allows for a broad range of post retirement options to be taken and the implementation of choices to be staggered between ages 50 (55 from 2010) and 75. Options are the same as present personal prensions, but without the obligation to buy an annuity by age 75. There is therefore the potential for the annuity market to grow very large but at the same time greater freedom for consumers not to go down the annuity route.
Other influences: Research into consumer attitudes to annuitisation suggests that a majority favour the abolition of compulsion and are opposed to annuitising at the point of retirement. However, few make maximum use of the freedom to defer annuitisation to age 75 at present. Supply side pressures on insurers, in particular shortage of and relatively low returns from long duration bonds, increases in lifespan and changes in capital assessment by regulators, suggest that rates for annuities may well continue to deteriorate.
Annuity providers and occupational pension schemes are the primary competitors for and users of long duration bonds. In principle, annuities could be bought from providers located outside the UK but within the European economic area (EEA). This has not happened to date for reasons including:
q Individuals would expect to be paid in sterling;
q Administrative obstacles, for example requirements for deduction and payment to the UK authorities of tax due on annuity payments;
q Annuities (DB) are generally with profits rather than fixed rate where offered in other EEA jurisdictions.
Prospects: The outcome of current changes may well be:
q A potential decline in total private pension provision;
q A greater share of retirement income emerging from DC pensions and consequently the potential for the annuity market to grow rapidly;
q A deterioration in the terms on which annuities can be purchased;
q An actual outcome for retirement income in which annuities form a smaller part of total income and more risk is retained by individuals opting for phased withdrawals, particularly among higher income retirees.
Mike Wadsworth is a partner at Watson Wyatt in the UK

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