Pros and cons of the age 75 rules and proposals

Will your clients benefit from the government’s proposed changes to pensions rules and what will be the best option for a secure income in retirement? It's time for advisers to find out, writes Fiona Tait of Scottish Life.

Although only a few individuals will be affected by the government’s consultation on the removal of the ‘effective requirement’ to purchase an annuity at the age of 75, the principles of increased flexibility and individual control are being emphasised and this should have a positive impact on a wider group of savers.

Before looking at the changes, it is worthwhile mentioning that the consultation document clearly states that ‘the purpose of tax-relieved pension is to provide an income in retirement’, and ‘many people will continue to choose an annuity as the best way of securing an income in retirement’. The proposed legislation is not intended to change this.

This is not a bad thing. People do need a regular income to meet their living expenses, and annuities give them the certainty that they will receive an income for the rest of their lives.

People are living longer in retirement, however, and the income stream must be stretched to reflect that. One way to do this is to purchase an annuity later in life; another is to avoid purchasing an income at all. The proposed changes could help some people to do this but the flexibility will come at a cost.

The main proposals

* The requirement to purchase an annuity or take an alternatively secured pension (ASP) at age 75, or any other specified age, will be removed. As a result ASP will cease to exist.

* It will be possible to delay access to pension benefits, including the pension commencement lump sum (PCLS) past age 75.

* The lifetime allowance (LTA) test will still apply at age 75 and contributions must cease.

* After age 75, lump sum death benefits will be subject to the recovery tax charge, likely to be set at 55%, whether benefits have been taken or not.

* Retirement income may be accessed via an annuity or drawdown plan, or a combination of both.

* Capped drawdown plans will be an effective continuation of unsecured pension (USP) plans with a maximum annual withdrawal limit.

* Flexible drawdown plans will allow individuals to access (taxed) lump sums in excess of the capped limit but only when a minimum income requirement (MIR) has been met.

* Lump sum death benefits paid after benefits have been taken will be subject to the recovery tax charge of 55%.

* Lump sum death benefits paid from pensions arrangements where benefits have not yet been taken will not be subject to the recovery tax charge, providing death occurs before age 75.

Retirees would have three options when they take income benefits: annuitisation, capped drawdown and flexible drawdown.

Feedback is due on the consultation by 10 September.

The choices the majority of people make between the three proposed options for retirement income will be no different than they are today. The majority of people will opt for an annuity; those who do not want to commit to a fixed annuity will look at variable annuities or income drawdown.

Annuities

As a drawdown specialist, I have not previously championed annuities but I believe most people will benefit from purchasing an annuity at some time in their lives. It is the only way to effectively guarantee that an individual will not run out of money if they live too long – assuming the provider stays in business.

The reason many people do not like them is they believe if they die in the early years, the remainder of their pension pot disappears into the insurance company’s coffers. But self-insurance is a risky strategy compared with an annuity.

Case study: Self-insurance versus annuities

One of the most dramatic cases I came across as a young pensions novitiate was a client who had purchased an annuity with a pension fund of around £350,000 and was killed in an accident about three months later. He had not purchased a widow’s pension or a guarantee.

This client had forgotten (or more likely had not been told) that an annuity is not a savings policy; it is effectively an insurance policy.

What could have happened if the client had not had to purchase an annuity and could have put it in the bank instead – in practice, self-insuring their retirement income? At age 65, the client has saved £350,000. He does not know how much income he can take but estimates he will live for another 15 years – the majority of people underestimate life expectancy.

Based on this, he decides to take out £20,000 a year, increasing at 3%. By the end of year 19, he has spent it all. He lives for a further 10 years and to continue with his required income he would need another £354,647.

This is the sort of scenario that annuities protect against. The maximum annuity income the client could take is £15,900 but it could last a lot longer.

Capped drawdown

In its present form, income drawdown appeals to three main groups of retirees:

• Those wishing to access PCLS but not requiring income;
• Those wishing to take varying income over time as their circumstances change;
• Those who need maximum income but wish to delay or avoid committing to an annuity.

Currently the minimum income level is £0 and the maximum is 120% of the Government Actuary’s Department standard rates. In effect, this allows just over the maximum level of income that an annuity could provide.

This upper level is designed to stop individuals from spending too much income and running out of money – it fits somewhere between self-insurance and an annuity income.

The Treasury has included in consultation the question of whether this limit – or cap as I suppose we will start calling it – should be reviewed (it does not ask about the minimum level).

It makes sense to look at this, but I do not believe there is an overwhelming case to make changes. Linking the maximum level to annuity income is in keeping with the insured approach above and should prevent overspending.

Although not the most important factor – certainly not to the end consumer – it must be borne in mind that any changes would necessitate system redesigns for the product providers. This would be justified if the end consumer were to see a significant benefit. But we should always avoid the change for change’s sake.

Flexible drawdown

Under the government’s proposals, individuals will be free to effectively self-insure their retirement income, albeit with the security of an underlying minimum income. It is likely that many people will be attracted to the idea of being able to take their fund as cash, so the level of the MIR is crucial.

If the MIR is set too low, people may spend their pension and be unable to meet their costs of living in later life. In particular the potential need for long-term care should be factored in. Figures from the Pensions Policy Institute show 80% of people who live to the age of 90 are likely to be affected by a moderate or severe disability.

The government is considering its approach to funding for long-term care and it makes sense to factor pensions savings into this. If the MIR level is set considerably higher than the basic level of means-tested benefits it could avoid an additional ‘death tax’ or additional insurance payments later on.

However, if the MIR is set at a fairly high level, individuals who meet the test are likely to be the ones who appreciate the value of keeping their savings in a tax-efficient environment and do not want the access to high levels of income that flexible drawdown allows, nor to pay the income tax charge that applies to it.

Stumbling blocks

Who would benefit from flexible drawdown? The government seems to envisage it working as a fall-back option, as described in the case study in the consultation paper (see sample case study below), rather than as encouragement to cash in fully. This is still likely to be relevant to a very small number of individuals however.

A further consideration is whether providers would be willing to offer this option. The Treasury appears to believe that product providers will carry out the necessary checks on clients’ secure income. A sensible approach would be to base the test on annuity/scheme pension income only and ask individuals to verify that they are receiving it.

This does stray into the territory of self-certification, which has been so detrimental to the mortgage market. However, unless the MIR is simple to calculate and easily verified, providers are unlikely to be willing to invest in the costly system changes that would be required.

Flexible drawdown: sample case study

Taken from the government’s consultation paper

Mr A retires aged 65 with a defined contribution pension. He decides to take 25% of his pot as a tax-free lump sum on retirement and invests the remainder in a capped drawdown arrangement.

At age 75, he decides to draw down a lump sum to pay for urgent repairs to his house. This requires him to secure a minimum income. He leaves the balance of his fund invested until his death at age 85.

After deducting a tax relief recovery charge, the unused funds remaining in his capped drawdown arrangement are passed on as a lump sum to his dependants.

Effect on product design

The proposed changes are unlikely to mean that fewer people will buy annuities per se, however it is possible they will begin to buy the annuities later in life. Improvements in life expectancy mean annuity decisions are being taken that could be effective for 20-30 years, which is a long time to run without any flexibility.

This presents an opportunity for annuity and drawdown providers to create more solutions to assist people through the prolonged transition period from full-time work into retirement.

Drawdown providers will be looking to develop investment options that move them closer to the secure income of an annuity; and annuity providers will continue to offer additional choices to bring them closer to income drawdown.

Developments in enhanced annuities could also lead to people staying in drawdown while they remain in good health and then purchasing an annuity when they can obtain more attractive rates.

Small pension pots

One group of people who may not benefit from these changes are the many who have only managed to build up small pensions funds by the time they reach retirement.

For these individuals, developments are likely to involve more cost-effective ways of accessing an annuity. They may not have the choice of income drawdown (capped or otherwise) but they can – and should – have the option of the best annuity available to them.

Early access to funds

An issue that is not included in this consultation but is on the government’s agenda is the intention to allow early access to pensions during financial hardship. Indications are that this is intended to apply to the PCLS element of the pension fund only, which limits the impact on eventual retirement income.

If this is the case, it could be a positive move and will have a more fundamental effect on pensions than the current proposals. Fortunately it is not a case of either/or – it looks as though the government is committed to making both changes.

Fiona Tait is business development manager at Scottish Life.