Annuities and a question of age
There are few things in life that are compulsory - but buying an annuity before the age of 75 from your own pension fund is one of them.
There is a small but vocal group of investors and industry professionals who have been campaigning to abolish this rule.
And now the new coalition government is planning to scrap the rules.
Before examining the new proposals it will be helpful to look at what all the fuss is about.Rules
Under current HM Revenue and Customs (HMRC) rules, those with a personal or company money purchase pension must buy an annuity once they get to the age of 75.
The original rules were designed when life expectancy was significantly less than it is now and most people had less complex financial affairs”
An annuity is a policy that exchanges your pension capital for a guaranteed income for life.
The advantage of an annuity is that it pays a secure income for the rest of your life, no matter how long you live. The disadvantage is that annuities are inflexible and if you die soon after taking out your annuity you (or, rather, those you leave behind) lose the capital.
This later point is not as bad as it seems because you can buy a joint life annuity.
There is a get-out option for those with larger pensions whereby they do not have to buy annuity at age 75 and this is called Alternatively Secured Pension (ASP) .
This option allows investors to draw an income directly from their pension fund without the need to buy an annuity and on death the pension can be transferred to their financial dependants.
However, if there are no dependants the fund must go to charity or be taxed at more than 80%. This option is complex and expensive and therefore only suitable for those with larger funds.Age row
The arguments against the age 75 rule were articulated by Lord Grantley in the House of Lords many years ago when he said: "In my view, there are two overwhelming reasons why people should not invest in annuities under any circumstances.
"The first is that investing in annuities is contrary to the interests of a family... in that they are worth nothing when the investor dies. The second reason is simply that annuities are a lousy form of investment."
The main objection to annuities is the fear of dying and leaving a huge amount of money to the insurance company, but this point has sharply divided the government from pensioners.
The government, the Treasury and HMRC have always insisted that a pension should be used for the purpose for which it was intended, that is to provide a pension income.
The thought that investors will use pension funds as a vehicle for passing capital to their family after their death is not always popular with politicians.
The second point, that annuities are a lousy form of investment, is simply untrue.
I will spare you the boring stuff about high yields and mortality cross-subsidy and simply remind readers that the only alternative to annuities is drawdown (taking an income directly from a pension fund) and many investors saw the value of their drawdown plans falling as a result of the credit crunch and volatile equity markets.
The would-be reformers argue that their pension funds are effectively their own cash, albeit with generous tax relief, and they should have the freedom to arrange their pension income in a way that allows them to leave an inheritance to their children.Changes
So what changes can we expect from the new coalition?
We expect the requirement to buy an annuity at age 75 to be removed and in its place a set of rules will come into effect, covering three main points. They are:
- What minimum level of guaranteed income must be paid from an individual's pension pot to ensure that they will not fall back on the state financial help if they invest their pension unwisely?
- How much income can be taken from the pension pot and when must it be paid?
- What happens when the policyholder dies? There will probably be a lump sum option less a tax charge.
It is too early to tell when and if the rules will come into force. In all likelihood it will take some time because the government has more pressing matters to deal with.
But if the compulsion to purchase an annuity is abolished, I feel it will be a victory for common sense because the original rules were designed when life expectancy was significantly less than it is now and most people had less complex financial affairs.
Today the average life expectancy of a 75-year-old is well over 10 years if they are in good health and it may be longer if they live a healthy lifestyle.
Many people's financial circumstances are more complex with the increased need for income flexibility to meet their more active lifestyles. Many argue that buying an annuity is like having a financial straight jacket.
I have long argued for the end of compulsory annuitisation at age 75 because I believe in freedom of choice, but this should not be confused with prudent advice that means that most people should consider investing in annuities before they get to age 75 in order to secure a guaranteed income for life.
The grass often looks greener on the other side, but rarely is. This means that anybody considering shunning annuities in favour of more complex arrangements should make sure they get expert advice.