Retirement Options

When you approach retirement, you have an important decision as to how to switch on income from the pension funds you have accumulated during your working life.

Some people will have final salary schemes that were arranged through an employer. These pay a pension income that is dependent upon your length of service and final salary.

Most people, however will have accumulated pension funds through a money purchase arrangement. This is where the amount of pension you receive is dependent upon the size of your pension fund and other factors such as your age, gender and benefits that you choose to build in to your retirement income.

Historically, low interest rates and increased life expectancy has significantly reduced the income you can expect to receive from your pension when compared to a decade ago. It is therefore important that the decision you make is the right one.

At retirement you do not have to purchase your income from the same company or companies with whom you have built up your pension funds. You have the right to an Open Market Option, which is the ability to transfer your pension funds to the provider offering you the highest income or most appropriate contract to meet your retirement needs.

You then need to consider how you want to draw your income. There are a number of options available, which include:

• Conventional annuity
• With profit annuity
• Investment annuity
• Temporary annuity
• Income Drawdown (now known as Unsecured Pension)
• Phased Retirement

The most appropriate option will depend on a number of factors including whether your retirement needs are fixed or flexible, your attitude towards investment risk, the structure of your other income and assets and the size of your pension funds. For those with larger funds, a combination of the options available may be suitable.

 

The main options are:

Annuity

An annuity is effectively the exchange of a lump sum of capital in return for a regular income.

In pension terms, you will normally be entitled to 25% of your pension funds as a tax free lump sum. The remaining 75% is then used to provide a regular income. There are a number of options you need to carefully consider when deciding how to structure an annuity, which include:

• Single or joint life
• Level or escalating income
• Guaranteed period

A single life annuity will cease on the annuitant's death (notwithstanding any outstanding guaranteed period). Many married people will need to ensure that their spouse is provided for should they pre decease them. This is done by building a widow or widower’s pension in to the annuity calculation (typically 50% or 2/3rds of the main annuitant’s income). A joint life annuity will be lower than a single life annuity because of the risk to the annuity provider that they will need to pay the annuity for a longer period of time. The appropriate level of survivor’s annuity will depend on a number of factors such as other pensions, income from other assets and income requirements should the main annuitant die first.

The choice of whether to choose a level or escalating income is difficult. On the one hand, the choice of an income that rises each year to ensure that one’s income keeps pace with inflation makes perfect sense. However, the way annuities are structured can make such an option unattractive to a lot of people. For example, an index linked annuity will typically start at around 65% of the income available from a level annuity. It takes around 11 or 12 years for that income to catch up with the level annuity, and a further few years to make up for the 11 or 12 years of shortfall. In other words, someone retiring at 65 may have to wait until their late 70’s or early 80’s before they are better off with an escalating annuity. A process known as demographic spending patterns suggests that as most people approach their 80’s, their pace of life tends to slow and therefore they do not need as much income as they become less active. However, depending on individual circumstances and preferences, it can be re-assuring to have some of protection against inflation”. This is therefore an important decision, and you need to consider your income needs, not just now, but also in the future.

A guaranteed period provides a minimum guaranteed period that the annuity will be payable for, in the event that the annuitant dies prematurely. A guaranteed period of 5 or 10 years can provide peace of mind that a pension fund built up at great expense over a number of years will at least provide some value to beneficiaries in the event of early death. This is typically inexpensive to build in to an annuity in comparison to either a joint life annuity or escalating income.

Enhanced annuities are available to those who may potentially have a reduced life expectancy because of either pre existing health conditions (cancer, heart problems etc) or lifestyle (i.e. smoking). Standard annuity rates are based on a combination of age, gender (men will typically receive better annuity rates than women because of a lower life expectancy) and gilt yields. It is usually necessary to provide details of pre existing medical conditions to an annuity provider to enable them to assess the level of enhancement they are prepared to offer.

Conventional Annuities

Conventional annuities offer a guarantee with regards to the security of the income that will be paid for the lifetime of the annuitant. They are therefore ideal for those who, having built up a pension fund they will rely on for life, do not wish to take any risk with their future income.

However, they are inflexible, and all of the decisions need to be taken at the time the pension fund is converted in to an annuity. For example, someone in good health at the time they purchase an annuity cannot then obtain an enhanced rate if they are later diagnosed with a medical condition that would have qualified for an enhanced annuity. If an escalating income is chosen at outset, it cannot be altered to a level income in the future. If a single life annuity is chosen, it cannot be altered to a joint life in the future.

Therefore, those who are prepared to take some degree of risk with their future income have more flexible options available to them.

With Profit Annuities

With profit annuities offer a more flexible option than a conventional annuity. The annuitant chooses a single or joint life and guaranteed period in the same way as a conventional annuity, but unlike a conventional annuity they do not choose a level or escalating income. Instead an Anticipated Bonus Rate (ABR) is selected. Government legislation allows ABR’s of between 0% and 5%, but the majority of annuity providers do not allow this level of flexibility within their own contracts. The level of ABR chosen influences the starting level of income received i.e. the higher the ABR the higher the starting income. If future bonus levels match the ABR selected the income remains constant. If bonus levels exceed the ABR income rises, and if bonus levels are lower than the ABR income falls.

 

With profit annuities allow the annuitant to change the ABR at selected times, which means that those with varying income needs can benefit from the flexibility this affords them. For example, a 60 year old male may well have more need for income from their pension for the next 5 years prior to the start of their State Pension than they will do thereafter. As such they may decide to use a higher ABR for this period to maximise their income, and then reduce the ABR (and income) at age 65 when they start to receive their State Pension. Many people like the idea of an escalating income, but are not prepared to accept the lower initial income necessary to facilitate this through a conventional annuity. Therefore they may decide to take a level of ABR that creates the same starting income as a conventional annuity with level payments in the hope that bonus rates will be sufficiently high enough in the future to provide a rising income. Of course there is the risk that if bonus rates are lower than required, then future income could actually fall.

With profit annuities also allow the annuitant to convert to a conventional annuity in the future (something that is not permitted the other way from a conventional annuity to a with profit annuity). This has to be done with the same provider with whom the with profit annuity is held.

Investment Linked Annuities

Investment linked annuities work on a similar basis to a with profit annuity, but rather than select an ABR to determine both initial and future income, instead it is the underlying investment returns that determine this.

There is the potential for income to rise in the future if investment returns are good, but there is also the risk that they could fall if investment returns are poor.

Temporary Annuities

Temporary annuities enable the annuitant to select a level of income from their pension fund for a fixed period of time, typically 5 years. The annuity provider will then use part of the pension fund to secure this income, and will provide a guarantee as to the value of the remaining fund at the end of the temporary annuity period.

At this point the annuitant can either purchase another temporary annuity, or select a conventional, with profit annuity, unsecured pension etc.

Temporary annuities enable the annuitant to defer the purchase of a lifetime annuity, which could be beneficial should they subsequently become eligible for an enhanced annuity.

Income Drawdown

Income Drawdown (or Unsecured Pension as it is officially known as) is a flexible way of drawing retirement benefits for those with larger pension funds (typically over £100,000), and who are happy to take a higher risk with their pension fund in order to take advantage of the additional flexibility Drawdown brings.

Tax free cash is available and taken at outset in the same way as with an annuity, and then the remaining fund is invested. An income is then drawn from the fund, which can be varied between £nil and what is known as maximum GAD (it is known as this because the figures are provided by the Government Actuarial Department). The maximum income is designed to be the same as that available from a single life annuity, but in reality is usually around 10-15% higher. If you do not require any or all of the tax free cash to which you are entitled, then Phased Retirement allows you a tax efficient way of mixing tax free cash and taxable income.

The value of the pension will fluctuate, rising where the growth of the underlying investments is greater than the income taken plus any charges, and falling where the investment return is lower than income plus charges. It therefore carries a higher risk than an annuity, and is only suitable for those who are happy to accept this higher risk.

The critical yield is a key factor when determining whether to choose an Income Drawdown arrangement over an annuity. This measures what the underlying investments of a Drawdown need to grow by each year to ensure you could still buy an annuity of the same level in the future (usually measured to age 75, where under current legislation an annuity or Alternatively Secured Pension needs to be purchased). The higher the critical yield, the more aggressive any investment strategy needs to be, and the less likely the prospects of the required investment return being achieved.

Income Drawdown provides a great deal of flexibility with regards to income levels and death benefits. Income can effectively be increased and decreased within the minimum and maximum permitted levels at any time, and these levels are reset every 5 years. Unlike an annuity, where death benefits such as dependent’s pension, guaranteed period or capital protection need to be built in at outset, with Income Drawdown no such decisions need to be made at outset. Should someone die whilst in Income Drawdown, their dependent has three options:

1. They can choose to continue with the Drawdown arrangement themselves utilising 100% of the remaining fund.
2. They can convert 100% of the remaining fund to purchase an annuity for themselves.
3. They can opt to receive a lump sum, but this is subject to a 35% tax charge.

Income Drawdown provides a great deal more flexibility and death benefits than other retirement options, but it does carry with it a higher level of investment risk.

Phased Retirement

Phased retirement provides a more flexible alternative for those who either wish to stagger their retirement, or alternatively do not intend to take any or all of the tax free cash to which they are entitled.

Typically at retirement tax free cash (usually 25% of the gross pension fund) will be taken and the remaining 75% is used to provide a retirement income, either through an Annuity or Income Drawdown (Unsecured Pension).

However, some people may wish to reduce their working week from say 5 days a week to 3. They may therefore need to start drawing benefits from some, but not all, of their pension fund in order to plug the income shortfall. Phased retirement enables part of the pension fund to be converted to income, via either an Annuity or Income Drawdown, whilst leaving the remainder invested until it is required.

Although the majority of people take the maximum tax free cash lump sum to which they are entitled at retirement, there are a minority who do not actually require this lump sum, and prefer instead to use all of the pension fund to provide an income. If the whole pension fund is converted in to either an Annuity or Income Drawdown, the income produced is taxable. Phased retirement enables the income produced to combine both tax free cash and taxable incomein order to maximise the tax efficiency of the income produced.

It also enhances the death benefits available from the pension. When an annuity is purchased, there are no death benefits except for those built in to the annuity at outset (widows pension, guaranteed period or capital protection). With Income Drawdown, a surviving spouse can continue with Drawdown or purchase an annuity using all of the remaining fund, or they can opt for a return of the remaining fund as a lump sum, but this is subject to a 35% tax charge.

With Phased retirement, any segments that have not yet been converted to income, are usually available to beneficiaries after death as a tax free lump sum.

There are a number of ways in which a retirement income from pensions can be taken, and there is no one size fits all approach. It is important that the consumer seeks independent financial advice to establish which option or options are right for them. Even if a conventional annuity is required, the difference between the top annuity provider and the worst can amount to several thousand pounds over a remaining lifetime, so it is important to seek advice to ascertain who is offering the best terms.

With careful planning you can ensure that your retirement is the enjoyable time you have worked hard during your working life for.

Ian Osang

Partner Ingard IFM LLP

01702-533438

www.ingardifm.com