The annuity plus approach
Last summer an industry group – the Retirement Income Working Party – gathered in the UK to look at the problems with pension annuities purchased from DC pension plans, and to suggest solutions to those problems. The group started from the premise that the state should have only two limited areas of interest in the use of pension monies accumulated during a working lifetime.
First, governments have a right to expect people to use savings to fund their retirement and not to spend it and fall back on state benefits. Future generations of taxpayers would no doubt disapprove of any alternative approach. The second premise arises from the tax-advantaged nature of many pension savings vehicles in Europe. Exchequers expect to regain during retirement the unpaid tax on the pension fund whilst it is saved. Hence any suggestion for change needs to guard against tax disadvantage to the state.
Even considering these two points, the group felt the accumulated sum was subject to too many restrictions. If individuals could prove they were able to survive without state benefit, then surplus funds could be used as the individuals wish. Tax regimes could be put in place to ensure that as the money was withdrawn and spent, so it could be taxed. Even if the fund was left until death, it should form part of the estate and be subject to inheritance (or other death) tax.
As a first stage, the government would define a level of income which individuals would have to prove they could achieve for the remainder of their lives. It was felt the government should set the appropriate level after considering all other state defined benefits, tax levels etc. However, the group recommended it should be above the state minimum income. The specific suggestion was for a sum which would be the average for someone retiring with entitlement to the full first tier basic state pension and a working lifetime’s contribution to the second tier pension (currently SERPS in UK).
This minimum retirement income (MRI) would have to be guaranteed for life to avoid the first problem outlined above and so it could include State benefits such as the basic state pension and any SERPS entitlement. Any income from DB pension schemes would also count. Once these sums were included, any shortfall from the MRI would be the sum to be funded from the DC pension pot or pots. Such funding up to the MRI level would be compulsory but would use DC funds only after any tax-free lump sum had been taken if wished.
Only an annuity would suffice to ensure that the individual could not outlive their assets but a level annuity purchased at retirement could still lead to the person falling back on the state at a later date as inflation bit into the value of the annuity. Hence the group recommended funding should be index linked up to the MRI level.
Once the MRI had been established for the given individual, any extra funds (called the ‘Residual Fund’ by the group) would be available for them to use with a far greater degree of freedom. Therefore, the proposals would, through the MRI, require the continuing purchase of annuities, and would enforce index linking. On the other hand, once this obligation was met, the person would be free to enjoy the sum they have saved. Monies remaining invested should continue to grow on a tax-deferred basis, although drawdowns would be subject to tax at the individual’s highest marginal rate.
One proposal was the creation of a new class of manager for the funds, perhaps to be called an approved pension manager. This would be a company, authorised under the Financial Services Act (currently) with freedom to manage the residual fund if the individual wished to move it from the annuity provider. The investment of the residual fund could then be added into the full range of investment options including unit trusts, investment trusts and OEICs. It would also allow funds to remain exposed to equity markets for longer than if they were used to buying an annuity. Also, those funds surplus to the MRI funding requirement, could be used to buy a different type of annuity.
The group considered whether a government might wish to impose restrictions upon the use of the fund, either by way of required minimum withdrawals or by setting a maximum that might be taken at any one time. These would be political decisions but overall the group concluded there was no overriding reason for any such restriction once the MRI was funded.
The group also felt the proposals would not add to demand for annuities, whose supply was a problem needing to be addressed, but would allow significantly greater freedom for additional sums. As more people retire with DC pension pots, the current restrictions on the use of accumulated funds would act as a disincentive to save. Allowing greater freedom, whilst still ensuring tax neutrality would, the group felt, add to the incentive effect of tax relief at the saving stage.
Joanne Hindle is one of the members of the RIWP and runs Miles Consulting in Bristol.
This is the second of her two articles (the first appeared in the April 2000 issue of IPE). The Full Technical Report of the Retirement Income Working Party is available at HYPERLINKhttp://www.bbk.ac.uk/ res/pi/reports/MarOO.pdf