Joanne Hindle of the Retirement Income Working Party discusses its findings on the problems of using annuities in pensions
The UK, in common with most of Europe, is facing a well-documented demographic problem with populations aging, declining birth rates and earlier retirement. One response, growing in popularity around Europe, is to encourage (or even compel) saving for retirement, increasingly in defined contribution (DC)-type vehicles.
A common feature of such vehicles is that upon retirement, whatever sum has been accumulated is transferred from the funds in which it has grown into an annuity arrangement. In the UK the restrictions upon the use of the fund are quite tight, resulting in, for most people, compulsory annuity purchase. Whilst the detailed regulations surrounding annuity purchase do vary from country to country, the requirement to purchase raises similar issues in the current environment. At a time of low inflation and low interest rates, now seen as the norm for the EU, gilt yields are also low – resulting in declining annuity rates. For many people therefore the annuity they must purchase is seen as very poor value for the fund, which has been saved over perhaps many years.
The requirement to buy an annuity, with its backing provided by matched gilts, also imposes a strain on a country’s gilt market. As EU requirements force member countries to constrain public debt, this leads to a decline in the issue of gilts, at the same time as, with aging populations, the demand reaches unprecedented levels.
These linked concerns led, in the UK, to the formation, in the summer of 1999, of an industry working party under the chairmanship of Oonagh McDonald, former financial services regulator. Its terms of reference were to stimulate a public policy debate on the future of compulsory annuity purchase. Its establishment followed the earlier publication of a report by McDonald, which examined the state of the UK annuity market and found a number of problems with it. The report of the working group has just been published and in this article and its sequel next month I will examine the background to it and the conclusions it reached.
In the UK currently, for anyone retiring with a DC pension pot, whether from an individual or group arrangement, or with funds from an AVC or FSAVC arrangement, only three limited choices are on offer. The same options will apply to those retiring in the future with sums from stakeholder pensions. Up to 25% of the fund may be taken as a tax-free lump sum. The remainder must be used to purchase an annuity or may be used to fund income drawdown until at the latest 75, when again the requirement to purchase an annuity bites. In income drawdown the capital sum remains invested and the individual draws income from the fund until the annuity is bought.
The option of drawdown has only been available since 1995 and is still relatively little used – although growing in popularity, making up 29% of the retirement income market in 1999. One reason for its lack of take-up has been that relatively large funds are required to make it worthwhile since on-going advice and regular reviews are needed, which incur extra costs. The growth in the fund must be sufficient to outweigh these costs if the decision to delay annuity purchase is to be worthwhile. Also the continuance of drawdown leaves the monies invested in, typically, equity funds, so a high degree of risk tolerance is required. Such an attitude to risk is less common amongst older people.
For the annuity itself there are few restrictions. Individuals may buy the type of annuity they wish, whether single or joint, level or index-linked. Only as regards any sums which represent rights accrued from contracting out of the state scheme are any restrictions imposed. There is a wide range of annuities on offer including with-profit, unit-linked, index-linked or escalating. Despite this, most people buy non-profit annuities and of these in 1999 about 80% were level.
The purchase of level annuities in itself gives rise to further problems. Of course, buying an escalating or index linked annuity results in lower payments at the start of retirement; perhaps 30% lower for a man retiring at 65.
Many people fear an immediate drop in income at retirement and so opt for the annuity giving the highest immediate rate. However many people underestimate the length of time they are likely still to live and find that in later years their income has dropped significantly as inflation has taken its toll. A man receiving an income of £8,333 a year at 60 would find it worth only £4,614 at age 80 even if inflation had run at only 3% throughout that period. This is also a problem for the state, since those with small pots would, in due course, fall back to claiming state benefits. Any alternative to compulsory annuity purchase should try to address this issue.
Given falling annuity rates it is not surprising that there has been growing discussion of the need for an alternative approach to retirement income. The UK requirements are also quite onerous compared with many other countries. Both Australia and Ireland for example impose no such requirement. In Ireland there is full freedom for the self-employed and owner directors, with further changes for others being considered. There is only a need to establish that one has funds, up to a certain level, available from any source invested in an approved minimum retirement fund. Beyond this the full sum saved may be taken as cash, 25% tax free and 7% tax paid.
The Australian system allows for withdrawal at any time after age 55 by lump sum or annuity. The annuity market is small, only 2% of retirees were receiving annuity income in 1992/93 and most of these were fixed term annuities. Only 16% were life-long. There is an alternative, known as ‘allocated pensions’, which resembles income drawdown. However the individual may exhaust the fund by age 80 and then claim state benefits. The government is aware of the problems inherent in this system and is starting to address them; for example, by 2025 withdrawals will not be available until age 60.
A further problem with annuity purchase arises as people are spending an increasing proportion of their life in retirement, as a result of early retirement and increasing longevity. The requirement to buy a one-off product, which then may well have to last for 30 years, seems inappropriate. During those 30 years many circumstances may change, ranging from a desire to do some part time work to re-marriage to a need for long-term care in the last years of life. None of these possibilities can be accommodated once an annuity has been purchased – it is a contract for life.
The long-term nature of the annuity contract, however, is also its key positive factor. Since no one can be certain precisely when they will die there is always a risk that they may outlive their funds. From a government’s perspective this raises the spectre of numbers of elderly people falling back on to state benefits for the last years of their lives. The annuity guards against this in guaranteeing that, no matter how long one lives, the sum contracted for continues to be paid.
Equally unlimited access to the pension fund may encourage the individual to spend it too quickly. Even if invested, the sum may not produce an adequate income since the person does not benefit from any cross-subsidy inherent within the annuity contract. Clearly within any group of purchasers, some will live a shorter time than than the average, some on average and some beyond. The assumed lifespan of those who die early effectively provides free assets to be used to fund those who live longer. Any purely individual arrangement gives up this benefit.
Finally, the state may have an interest in the use of retirement income funds, beyond that of ensuring that people do not become benefit claimants late in life. In the UK, and many other countries, tax reliefs are given as the sum is saved. Hence the tax authorities seek to recoup those sums when the pension is in the payment stage. In that way the tax reclamation is merely delayed rather than foregone. If people were given unlimited access to their funds at retirement there could be negative tax consequences and a cost imposed on the exchequers of any countries, which went such a route. Hence any solution, which changed the annuity requirements, with annuities currently being taxed in payment, should aim to be broadly as tax efficient if it is to gain government acceptance.
The broad proposals of the retirement income working group, which try to address these various concerns are summarised in the box. They will be discussed fully in a further article next month.
Joanne Hindle is a member of the Retirement Income Working Group. Formerly with NatWest Life, she now runs her own consultancy
The report of the Retirement Income Working Group makes four main proposals:
q An individual should remain free, as now, to take a tax-free lump sum (usually 25%) on retirement.
q On retirement an individual must buy an index-linked annuity sufficient to cover a government-defined minimum retirement income.
q After achieving the required minimum income the individual should have much greater freedom as to how to use remaining pension funds.
q The current shortcomings of annuities should be addressed by government and the financial services industry.