If you read nothing else, read this…
• The government is removing the requirement to select an annuity by the age of 75.
• Pension schemes are legally required to offer the open market option, but many employees do not exercise their
right to shop around for the best deal.
• Variable annuity products offer employees more flexibility.
Choosing the right annuity is crucial for pension scheme members and guidance is essential, says Nicola Sullivan
Buying an annuity is probably one of the most important financial decisions an employee will ever make, so employers must provide the right support and guidance. However, The Pensions Regulator, which published a guide for employees, Making your retirement choices, last November, is concerned about the number of staff who do not take advantage of the open market option. This allows a pension scheme member to shop around to convert their pension pot into an annuity, rather than simply taking up the annuity offered by their pension provider.
A review of retirement information for defined contribution (DC) members, published by the regulator in 2009, found only 23% of scheme members exercised the right to take up the open market option, despite 98% of the 97 trust-based schemes surveyed offering access to it. Bill Galvin, chief executive of The Pensions Regulator, says: “Members could miss out on a higher retirement income because they are not well supported in making choices. Our research shows standards of information are mixed. Retirement literature should grab members’ attention and motivate them to take action, rather than putting them off with jargon and legalese.”
Employers must also consider the impact of legislation. For example, the 2011 Finance Bill, includes the removal of the requirement to select an annuity by age 75, which will take effect on 6 April 2011. This will allow those with DC pension savings from which they have not taken a pension to defer their decision to take the benefits.
Also, staff with a lifetime pension income of at least £20,000 a year will be able to access their drawdown pension funds without any cap on withdrawals. Mike Morrison, head of pension strategy at Axa Wealth, says this may be complicated for some employers to honour without transferring people out of an occupational pension scheme, because some scheme rules stipulate when an income stream should be bought.
“A lot of [organisations] would not want the extra administration and the extra cost of changing the scheme rules,” he says. “The question will be, if employers have a senior employee saying ‘I have seen these new rules, this new flexibility – can I take advantage of it?’, is how will the HR department react? Does it say ‘sorry, our rules do not allow that – you will have to do something to transfer yourself out’? Or will employers bring in an amendment of the existing rules?”
The abolition of compulsory annuitisation, plus the axing of the default retirement age, may also affect the fund choice. Gemma Goodman, head of operations at the Annuity Bureau, says that if an employee does not know when they want to take their pension and is invested in a lifestyle arrangement that moves funds out of equities the closer they get to retirement, they may want to look at where their funds are invested.
But few people leave it until after age 75 to take an annuity unless they want to use income drawdown, which only suits those with big pension pots, says Goodman. “We do not look at drawdown unless someone has a fund of a quarter of a million [pounds].”
Some annuity products recognise the need for flexibility when securing a retirement income. For example, Axa Wealth offers a variable annuity that guarantees the return of invested capital or income at the end of a certain period or in the event of death.
“[This product] is probably for people with larger pension funds and mid-range pension funds of just over £100,000,” says Morrison. “It has been developed because a lot of people understand annuities offer absolute security but perhaps limited investment opportunities. At the other end of the spectrum there is income drawdown, which offers no guarantees but lots of investment risk.”
This kind of product, therefore, provides an element of secured income from an annuity, combined with the flexibility of an unsecured pension.
Goodman adds: “If an employee buys a fixed-term annuity, even for five years, things will change, maybe their health will deteriorate. If they bought an annuity when they retired, they would not have benefited from the enhanced rates. Perhaps their partner’s health has changed or they have died.”
At one time, annuities were based solely on gender and age, but some are now based on life expectancy, so staff who are smokers or have existing health conditions are more likely to secure competitive deals. Some annuities even take into account where staff live because those living in certain areas are seen to have a lower life expectancy.
Insurers in the annuity market also change their rates depending on how much business they want to take on. Laith Khalaf, pensions analyst at Hargreaves Lansdown, says: “Insurers change their rates to determine the amount of business they get. They keep an eye on the rates other insurers are offering and sometimes, when they want to take on business, they might offer a slightly better rate then their competitors.”
Annuity rates are also affected by the yields on gilts, which relate to an investor’s appetite for risk. For example, the least risk averse are less likely to invest in assets such as gilts and bonds, which means the yields on those assets rise. “Of late, annuity rates have perked up a bit,” says Khalaf. “There has been a bit of a flurry of activity and the momentum seems to be upward rather than downward. We have around two years of sustained downward trends in annuities, which has not really abated until fairly recently.”
So, when it comes to annuities, it is important for employers to keep abreast of legislation and market conditions, as well as their legal obligation to offer staff the open market option.
Factors affecting annuity rates
• An employee’s health, lifestyle choices and location can affect the rate they get for an annuity, for example smokers will qualify for enhanced rates.
• Annuity rates are influenced by the yields on gilts, as well as inflation and interest rates.
• Employees will increase their chances of securing a competitive rate if they use the open market option.
• Insurers alter their rates depending on the amount of business they can manage.
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