Pensions and Annuities

Successive legislation has radically altered the face of pensions in recent years and many people now require advice to ensure that their plans remain the most appropriate for their circumstances, and take advantage of the new rules where possible without falling foul of the many pitfalls, particularly for those with more substantial funds.

New contribution limits to pensions and new rules giving greater flexibility with tax-free cash and drawing pension benefits demand higher standards of advice and planning to maximise tax saving opportunities.

At Foresight our approach to pensions stems from the full financial review where we establish the level of income you desire at your intended retirement age and from this we can develop a ‘target funded’ approach where you will know how much pension is required, removing the fear of the unknown where you never know how much pension funding is enough.

We are able to advise on all aspects of pensions from individual and group stakeholder arrangements, Personal Pensions, Additional Voluntary Contributions, Executive Pensions, Small Self-Administered Schemes (SSAS’s), Self-Invested Personal Pensions (SIPP’s). Three members of the Foresight team hold the coveted G60 qualification and we are therefore able to comprehensively advise on all pension transfer issues and other technical aspects of pension legislation.

Personal and Stakeholder pensions

Introduced on 1 July 1988, originally aimed to give people who were not part of a company pension scheme their own portable pension, designed on a money purchase basis although since April 2006 most individuals who are members of company pension schemes can also take out personal pensions.

Legislation for personal pensions and stakeholder pensions are identical (only the charges and product terms are set for stakeholder).

Self Invested Personal Pension (SIPP)

For many people the Self Invested Personal Pension Scheme (SIPP) will become the most attractive and Tax efficient method for long term saving featuring strongly with regard to their retirement planning. A SIPP shares the same regulation as Personal Pensions, described above, in respect of contribution and benefit levels.

A SIPP will allow regular and lump sum cash payments, and you will also be able to transfer other pension arrangements into the scheme. If you are employed, your employer can also pay into the plan. The key difference between a Personal Pension or Stakeholder Pension and a SIPP is the greater investment flexibility and choice available within the SIPP itself, which will allow investments from a wide range of sources including Commercial Property, shares and unit trusts.

When taking pension benefits there are now a myriad of options available from the humble traditional annuity where an income is secured for life with an insurance company in exchange for a lump sum to more complex arrangements such as Temporary Annuities, With Profit or Investment-Linked Annuities, Unsecured Pensions (formerly known as Income Drawdown) and the more recent addition of Alternatively Secured Pensions for those aged over 75.

Annual Allowance.

Since 6th April 2006, annual pension contributions have a new limit attracting full tax relief. This limit is the greater of £3,600 and 100% of salary, subject to the annual allowance (£235,000 in the 2008/2009 tax year). Any contribution over the annual allowance will be subject to a tax charge. We will explain this in further detail later in this section.

Lifetime Allowance.

As well as an annual allowance charge, there is a possible lifetime allowance charge if total pension funds exceed the lifetime allowance at when pension benefits are taken.

The lifetime allowance is £1.65 million in 2008/2009 rising to £1.8 million in the 2010/2011 tax year. The lifetime allowance charge is applied to the excess over the allowance. This can apply in two different ways or both depending on how the excess is taken. The individual charges are;

• 25% if taken as income, and

• 55% if taken as a lump sum

It is unlikely that there will be much difference because, if someone takes the excess as income, they will be charged income tax on top of this tax charge, more than likely at 40%.

Benefits

For individuals aged 50 before 6th April 2010, you can currently take pension benefits between ages 50 and 75. Normally these will be in the form of 25% of the fund as tax free cash, and the rest applied to produce an annual pension although other alternatives are now available. For individuals who reach their 50th birthday after 6th April 2010 the new minimum retirement age will rise to 55. If you are concerned this change in rules might affect you then please do contact us for further advice or guidance.

Level and bases of reliefs from taxation are subject to change.

Annuities

An annuity is an investment sold by insurance companies. It is a way of converting a lump sum, usually a pension fund built up during your working life, into an income for the rest of your life. Unlike other investments, it cannot be used up - however long you live.

There are different annuities to suit different needs. The main types are:

level;
increasing;
and investment linked

The amount of income an annuity will pay depends on:

the amount that you have in your pension fund;
your age, sex and your health at outset;
the benefit options that you choose, such as whether it's just for you or for a partner as well.

The amount of income an annuity provides each year in return for the lump sum from your pension fund is called the 'annuity rate'. Annuity rates are usually quoted for a man or woman of a given age. You may see an annuity rate expressed as a percentage. For example, an annuity rate of 6% is the same as £600 a year income for every £10,000 invested. Annuity rates change frequently, so do shop around for the best deal as you near retirement.

Usually, the starting income from the same size of pension fund is higher for a man than for a woman, assuming they are the same age.This is because, on average, men do not live as long as women of the same age.

The income that you get at the start of an annuity is higher the older you are. This is because, on average, an older person has fewer years left to live than a younger person. So, an older person's pension fund does not have to last so long. You can usually choose for your income to be paid every month, every three months, every six months or once a year.

You can also usually choose to be paid in advance or in arrears - you normally receive less if you choose payment in advance, although you would get your income sooner.

Enhanced Annuities

Some companies pay you a higher than normal income if you have a health problem or a lifestyle that threatens to reduce your lifespan. Relevant health problems might include, for example, cancer, heart attack, asthma, diabetes, high blood pressure. You may even qualify for higher rates if you are overweight or you smoke regularly. It is estimated that 40% of people could benefit from an enhanced or impaired life annuity. Some of these conditions on their own may not be enough to qualify for an enhanced annuity.

Level Annuities

Sometimes called a 'standard' annuity, pays the same income each year for the rest of your life. The main drawback with a level annuity is that what you can buy with the income falls as prices rise through inflation. For example, suppose at the start of your retirement your weekly food shopping cost £50 a week. If inflation averages 3% a year for 10 years, their cost would rise to £67 per week. If you could still only afford £50 then you would have to buy fewer groceries. That is the effect of inflation. Level annuities pay a higher starting income - compared to increasing annuities. Think carefully about the effect of inflation. Could you really cope with having no increases at all in your annuity income during your retirement, which could last 30-40 years?

Increasing Annuities

To protect your income from rising prices, you can choose an annuity that is designed to increase each year. There are two main choices:

escalating annuities - your income is guaranteed to increase at a fixed rate each year, commonly 3% or 5%.

RPI-linked annuities - your income is adjusted each year to reflect changes in the Retail Prices Index (RPI) - the main measure of inflation used by the government. So, if inflation is 3% one year, then your income goes up 3%. If inflation is 10% next year then your income goes up by 10%. However, your income is not guaranteed to increase each year - if the RPI didnot rise, nor would your income. If the RPI fell, so would your income.

With an increasing annuity, the starting income is a lot lower than you would get from a level annuity. For example, for a man aged 65, the starting income from a 5% escalating annuity might be two-thirds or less of the amount from a level annuity. It could take more than 10 years for the escalating income to catch up, and nearly 20 years before the total that you would have received from the escalating annuity exceeded the total from a level annuity.

Level or increasing?

You need to weigh up whether you think you will live long enough to benefit from the protection against inflation offered by an increasing annuity. Your income requirements may reduce as you become less active in older life - a level annuity may work well for you in a low inflation economy, which we are experiencing just now, but should inflation dramatically increase you may find the purchasing power of your annuity sliding too quickly.

Investment Linked Annuities

The chance of a higher income in the future - but only by taking extra risk.

Investment-linked annuities offer the chance of a higher income than you can get from level of increasing annuities (often called 'conventional annuities') linked to fixed interest assets such as gilts and bonds. But you need to be comfortable with linking your income in retirement to the ups and downs of the stockmarket. Investment-linked annuities are more risky than conventional annuities because: your income is likely to change each year, so could go down as well as up. the size of any increase is unpredictable If the risk of an unpredictable and possibly falling retirement income worries you then stick to conventional annuities.

With-profits annuities

These link your income directly to the performance of the insurance company's with-profits fund. Typically, your income is made up of two parts:

a minimum starting income - this is usually set at a low level but, unless investment conditions are very bad, you will usually get at least this much income. Some with-profits annuities guarantee it;

bonuses - The insurance company usually announces bonuses each year. Bonuses can be 'reversionary' (usually announce once a year and guaranteed to pay out for the duration of your annuity) and 'special' - these only pay out a year or so until the next bonus announcement. The amount of any bonus depends on many factors, the most important of which is stockmarket performance. Some insurance company's may guarantee a bonus rate, for example 3% a year. Sometimes you can choose the guaranteed rate, but the higher the guarantee, the lower your starting income.

Usually, your starting income is based on an 'assumed (or anticipated) bonus rate' ABR. You choose the ABR at the outset from a range set by the insurance company - for example 0% (which assumes no bonuses at all) to 5%. Once chosen, most insurance companies do not allow you to change the ABR.

Your choice of ABR may depend on your need for income. For example, suppose you intend to carry on working for now. By choosing a low ABR you can plan for a low income now, increasing by the time you fully retire.

The insurance company announces new bonus rates every year. If the rate equals your chosen ABR then your income does not change. If the declared bonus is higher than the ABR, your income increases. But, if the bonus is lower than the ABR then your income falls.

If you choose a low ABR, your starting income is low. But, you increase the likelihood that future bonuses will exceed the ABR and that your income will rise. You also reduce the risk that your income will fall. If you choose a higher ABR, your starting income will be higher.

If you choose the lowest ABR of 0% - in other words, assuming no bonuses - your starting income will be the minimum. As long as the company declares a bonus, your income will increase. In general, your income cannot fall because the bonus rate can never be lower than 0%. (However, if long term stockmarket performance was very poor, even this minimum starting income could be cut, except in the case of with-profits annuities that guarantee the minimum).

Unit linked annuities

Your income in retirement will be linked directly to the value of an underlying fund of investments. Generally, you can choose the types of fund, for example:

medium risk managed fund where the fund manager selects a broad range of different shares and other investments - spreading your money widely reduces risk;

higher risk fund where a fund manager selects shares and other investments in a particular country - Japan, say - or sector, such as smaller companies or technology companies. Because your money is less widely spread, the risk is higher;

tracker fund (usually medium risk) which tracks the performance of a particular stockmarket index like the FTSE-100 (top 100 UK companies by market value). Usually, these have lower charges than managed funds.

The more risky the underlying fund you choose, the more your retirement income may vary - both up and down.

Some unit linked annuities work in a similar way to with-profits annuities. Your starting income is based on an assumed growth rate (similar to the assumed bonus rate). If the fund grows at the assumed rate, your income stays the same. If growth exceeds the assumed growth rate, your income increases. If growth is less than the assumed rate, your income falls. A few unit-linked annuities let you invest in a 'protected fund' which limits the fall in your income.

Most unit-linked annuities do not guarantee any minimum income. Even if your income is based on an assumed growth rate of 0%, your income could still fall if the underlying investment fund falls.

Are investment-linked annuities for you?

You should not consider a unit-linked annuity unless you can cope with an income that can swing widely and may fall. You would need a large pension fund or other sources of income (or both) to fall back on. Unit-linked annuities are higher risk than either conventional or with-profits annuities.

Annuities if you have a partner

Make sure your partner will still have an income if you die.

Both conventional and investment-linked annuities can be `single-life' or `joint-life last survivor'.

A single-life annuity pays out only during your own lifetime.

A joint-life last survivor annuity pays out until the second person of a couple dies.

On the first death, some annuities carry on paying the same amount to the survivor. With others, the amount is reduced for example, by a third or a half. You usually choose at the outset how much income you want the survivor to get.

If you have a wife, husband or partner who is financially dependent on you, you should normally choose a joint-life last survivor annuity unless you have other assets or income for your dependants to live on after your death.

With some pension schemes, it is the law that you must opt for an annuity that provides a pension for your widow or widower equal to half the income you were getting. Your provider can tell you if this applies to your plan or scheme.

Annuities with a guarantee period

If you die soon after taking out an annuity, it will not have paid out much. To guard against this, you can choose an annuity with a guarantee period.

These sorts of annuity commonly guarantee to pay out at least five or ten years' worth of income, even if you die within this period. On your death, the income may continue to be paid for the rest of the guarantee period, or it may be paid as a lump sum to your estate (and inheritance tax might be due on it).

If anyone is financially dependent on you, do not look on a guarantee period as a substitute for a joint-life last survivor annuity.If you live to the end of the guarantee period, the survivors will get nothing.

Value Protection - a new benefit should you die before age 75 People are often concerned they may not see the full value from their annuity if they pass a way in the early years - value protection means this eventuality is taken care of.

A lump sum can be paid out in the event of death before age 75 but you are also safe in the knowledge that income will be paid out for life, even if that is longer than you had planned for financially.

You can choose to protect up to 100% of the value of your pension fund. Adding value protection will reduce your pension income and you need to be sure that you can still meet your needs.