Do you understand how annuities work?
Millions will be auto-enrolled into a system that is not fit for purpose
The Government is encouraging millions of workers to save in a pension scheme to improve their retirement income. If you are a worker earning above the tax threshold you will be automatically enrolled into company pensions and (assuming you do not opt out) you will be paying contributions for many years to build up a retirement fund. Most new auto-enrolment pensions will be what are called ‘defined contribution’ pension schemes, which just collect your own and an employer’s contributions (if any). These are also known as ‘money purchase’ pensions, because you use your pension ‘money’ to ‘purchase’ a pension income. Unlike final salary-type pensions, where your pension fund and employer guarantee you a particular level of pension, most auto-enrolment pensions will leave you responsible for the income you receive. So the income you receive in later life will depend on what you choose to do with your fund.
So what happens at retirement if there is no promised pension amount?
When you reach retirement, you cannot just take your pension savings and spend the money as you wish. There are strict rules and restrictions on how you can take money out of your pension fund. Most people with defined contribution pensions are encouraged to buy an annuity to provide their income for life, but you may not be told that you actually do not have to. Buying an annuity is a difficult and irreversible decision, with no second chances. If we want auto-enrolment to work well, we need to address the shortcomings of the current annuity and at-retirement pension decision process. Let me try to explain some of the important issues.
What is an annuity?
An annuity is a financial product you buy from an insurance company, which pays you a regular ongoing income from your pension savings. So the annuity income is your pension. Most workers have no idea what an annuity is, how it works, what the process involves and what it will mean for them in the long run. Buying an annuity involves giving your pension fund to an insurance company which then promises to pay you money from that fund for the rest of your life. The standard annuity pays a fixed level of income, that is set on the day you hand over your pension fund, and will carry on paying until you die. This is called a ‘single life, level annuity’ since it covers only you, not your partner, and the income will remain at the same level every year. There is usually no protection against inflation. Once you have bought an annuity, (unless it is a special type) you can never change it for the rest of your life. It is therefore vital that you understand what you are doing before you make this irreversible decision.
Are annuities safe?
Annuities may provide a ‘safe’ income, but you could lose all your capital. If you die relatively young, you will lose all your money as the insurance company will keep most of your pension fund. In fact, unless you live much longer than average, you will not even have your pension fund value returned to you. Annuity rates have fallen sharply as a result of several factors, including the lower interest rate policies of the Bank of England. That means, those reaching retirement recently will receive lower income for the rest of their life. In fact, annuities are not a ‘low risk’ option for securing retirement income at age 60 or 65.
Annuities are not simple or straightforward.
The decision about what to do with your pension funds is complicated and depends crucially on your own personal circumstances.
|TYPES OF ANNUITY|
|Single life annuity||Pays the pension income for your life only. When you die there is no pension for your partner|
|Joint life annuity||Pays pension income to your partner until he or she dies, if you die first|
|Level annuity||Amount of pension income is the same each year, with no inflation uprating|
|Escalating annuity||Pension income increases by a set amount each year (e.g. 3% or 5% etc)|
|Index-linked annuity||Pension income increases by inflation each year|
|5 year guaranteed annuity||If you die in the first five years after buying the annuity, the pension income will keep being paid into your estate until 5 years has passed from the purchase date|
|10 year guaranteed annuity||If you die within the first ten years after buying the annuity, the pension income will keep being paid to your estate until ten years after the purchase date|
|Value protected annuity||If you have not received back the full value of the pension fund, the balance will be paid to your estate when you die (this is taxed at 55% however)|
|Enhanced annuity||Pays you a pension income that is higher than a standard annuity to reflect special factors that suggest you will not live as long as the average person|
|Impaired life annuity||For those who are in ill health, higher pension annuity income is paid to reflect their shorter life expectancy|
|Phased annuitisation||Pays a fixed level of income for only, say, five years and then another annuity can be bought afterwards|
|Temporary annuity||Annuities that do not pay out for life, only for a set period of time|
|With profits annuity||The pension income can increase or decrease depending on the performance of a with-profits fund|
|Investment-linked annuity||The pension income will depend on the performance of an investment fund, but usually has some minimum income level guaranteed|
|Guaranteed annuity||The pension income is guaranteed at a minimum level and can rise in future depending on how the funds are invested|
Buying annuities is complex and risky, and most people do not understand how annuities work, nor realise the risks they are taking on when they buy one. They need an independent adviser to discuss this with and help with this complex financial decision.
What are my options when I reach pension age?
You have many options, which you need to consider in order to make the most of your pension savings. The first option is to ‘do nothing’. You should consider whether you actually need to take any income from your fund at all at the moment. If this is a small pension fund, it may pay you only a tiny amount of income (for example, a £10,000 fund would give you just over £10 a week). If you have other pensions, or if you plan to keep working, you may be best advised to leave your money invested for the moment. The second option is to buy an annuity, this is the option that the majority of people believe is required of them. Most people assume that this is what they need to do. Buying an annuity is, however, not a straightforward decision. Apart from there being many different types of annuity, it can cost you or your family a huge amount of money if you make the wrong decision. Those who have larger pension funds who do need some immediate income, can take some money from their pension fund each year instead of buying an annuity, while leaving the remainder invested. This involves buying a different product called ‘income drawdown’.
How do I know if an annuity is the right product for me to buy?
Most people need help to work out what they should do with their pension savings. Everyone’s circumstances will be different and they ideally need specialist and independent financial advice. Most people will struggle to understand all the different terms and types of annuity. Many will also not realise they could be better off not annuitising at all right now. They cannot make these decisions on their own, yet the current annuity selling system will not support them properly to achieve the best outcomes.
With annuities, the d-i-y option often costs more than top class service.
Annuities work differently from most other markets. What would you expect to cost more – paying for a chauffeur driven limousine to take you to your desired destination, or buying a bus ticket and finding the way yourself? Or what do you think would cost more – having a travel agent put together an itinerary for you holiday after discussing what you want, recommending the best hotels, booking it all for you and arranging the tickets, or going on-line to check out all the information on your own, find the best flights and hotels, book all the transfers and tickets yourself? When it comes to annuities, the do-it-yourself option can be the same price or cost you even more! Using an adviser is not a waste of money. It is a really important element of making the right decision for yourself and your loved ones in retirement.
Isn’t buying an annuity just a question of shopping around?
Just shopping around for a ‘better rate’ is nowhere near sufficient to make the most of your pension savings and ensure you are doing the best thing for yourself and your family. Just going to an annuity broking service cannot give you individual advice. For example, the annuity with the best starting income may not be the best thing for you to buy. Over the course of your retirement, and that of your partner, you could make much better use of your pension savings by considering other options. This will require advice. There are many companies that can advise you.
Won’t I have to pay for this advice?
Of course, an independent expert adviser needs to earn money for their advice. Just like a solicitor or an accountant, or even a plumber or electrician, if they are helping you with something complicated, they need to be paid. Seeing an adviser who can go through your pension and income needs and discuss your own personal situation with you, should get you individually tailored advice that is right for you.
What will an adviser do for me?
The adviser can first verify whether buying an annuity at the moment is the right thing for you and, if so, whether you should put all your pension funds in at once, or perhaps only a part of the money. Independent Financial Advisers (IFA) will deal with the necessary paperwork, help find the right product, look at all the providers in the market (most on-line services do not cover the whole market) and offer regulatory protection if things go wrong. When you take financial advice, the adviser will usually help you make sure that you do not leave a partner with nothing from your pension savings if you should die unexpectedly soon. The adviser will often talk to you both together, to help you make the right decisions. An adviser can also haggle with insurance companies to obtain a better quote for you, especially if your health is less than perfect.
What will the independent adviser charge?
If you consult an independent adviser, they must tell you how much you will be charged before you start. The Financial Services Regulator (FCA) introduced new rules, starting in 2013, following the Retail Distribution Review (or RDR), which mean advisers cannot take commission out of your pension fund without agreeing the amount with your first. These rules are designed to prevent advisers from having an incentive to sell you products that paid them large commission without your knowing in advance how much they would be paid by the company whose products you were buying. So the adviser will tell you how much the advice will cost you before you s start the process of deciding on what to do with your pension fund. Unfortunately, this puts many people off using independent advisers.
But if I buy direct I don’t have to pay for any advice
The strange thing about annuities is, even if you do not use an independent adviser, you will normally still have to pay anyway, just to buy the annuity. And buying through a self-service broker can even cost more than buying with the help of an adviser. So, advisers cannot charge commission but if you go on-line and buy direct, you will have to pay commission and could be charged even more than an adviser would charge, without having the benefit of someone to advise you individually to ensure you actually get what you need.
Will an annuity broker get me the best rate?
A self-service or on-line broker may not provide you with the best quote in the market, since these broking services do not cover every provider. They will only be able to check the rates of the companies that are on their database. On-line annuity services often do not cover the ‘whole of market’. That means they will not always be able to find the top rate for you when you want to buy. New companies are entering the market, often offering better rates in order to gather business, but only a specialist adviser will know which companies are around at the moment. If you buy on-line and the service does not yet include the new entrants, you could miss out on the best rate. If you miss it, you will end up poorer than you need to be for the rest of your life.
Will the on-line brokers get me the best rate for an enhanced annuity?
Enhanced or impaired life rates that are quoted on-line will often be lower than those available through an adviser who can ensure more detailed information is provided for the quote. The on-line services ask you to fill in questionnaires on line which will often point out to you what factors you need to consider when deciding on buying an annuity. However, these questionnaires are generic and will not ensure you know all the implications of buying the different types of pension annuity income on offer. They will ask health questions and ask you about a partner, but the information you provide will be generic, not specific to you. That means the annuity rates they offer you will be more general rates, based on broad information, rather than individually tailored to your own particular circumstances. These rates will often not be as good as if you have an individual assessment with more detailed questions. In addition, an adviser can haggle with insurance companies for a better quote than you are first offered. It is common nowadays for insurers to increase their quote in order to secure the sale, but with an on-line service most people do not have the chance to go back and ask for a higher quote.
What if I decide to just buy the pension offered by my pension company, do I still have to pay commission?
If you just take the annuity income offered to you by your pension company, without going to an adviser and without shopping around or using an annuity broker, you still have money deducted from your pension fund when you buy the annuity. Your pension company can take around 2% of your pension fund and keep that money. They do not have to give you any advice, or make sure you have received any help. They can sell you the wrong type of annuity to buy, and it may not be the best rate in the market for this wrong type of annuity – there is no regulatory control on this. The pension company can just keep that money if there is no adviser to pay it to. So, if you have a £50,000 pension fund, your insurance company will help itself to between around £1000 of your money and once you have bought their annuity you are stuck with this annuity for life.
If my pension company is in the best buy tables should I assume they offer best rates?
Definitely not. Annuity pricing is not straightforward. There will be times when an insurer will want to sell annuities and will offer competitive prices, which may put them in the best buy tables, but there will be other times when that same company may not want to take on any more annuity business for a while and will then offer poor rates, compared to the rest of the market. In order to sell annuities, companies must hold regulatory capital to back the annuity sale. Usually, this means holding a certain amount of gilts or high quality bonds to satisfy the regulators. If a firm has sold significant amounts of annuities recently, it may not have enough regulatory capital at that time and, therefore, will not want to take on much more business. It will therefore drop its rates, offering much worse value, and if you buy from the company at that time, you will not get a good deal. That is why it is so important to shop around the whole of the market.
Annuities can be very risky – but most people think they are low risk products
If you buy a financial product that can lose more than three quarters of your money, it would usually be considered ‘high risk’. Buying a standard annuity without any guarantee could mean losing all your money and, even with a five year guarantee, you could lose nearly three quarters of your money. Yet people often say that buying an annuity at retirement is the low risk or even ‘no risk’ option.
What are the risks of buying a lifetime annuity?
Buying an annuity is not a ‘safe’ option. Retirement exposes pensioners to significant risks which an annuity cannot protect them against. An annuity purchase is a long-term investment decision, which can carry huge risks of losing much or all your money, yet people are given no risk warnings about the dangers of buying. The main risk that a standard annuity covers is the risk of living a very long time. Those who live into their 90s will probably get some value from their annuity, but the majority of people will not live that long.
Their pension income from a standard annuity will not provide cover for most of the risks they face during their retirement:
|Annuities leave you open to risks|
|Dying relatively young||If you die soon after buying your annuity you risk losing most of your pension savings|
|Inflation||If inflation rises, your level annuity becomes worth less and less each year|
|Strong investment returns||If investment markets are strong, your pension fund cannot benefit|
|Rising interest rates||If interest rates rise, you cannot benefit from better annuity rates in future|
|A change in personal circumstances – such as spouse getting ill or dying||Locking into an annuity at age 65 means any change in personal circumstances will not be reflected in a better pension income in future|
|Becoming ill – or more seriously ill||If you buy an annuity in good health and then become ill, or if you have an enhanced rate but become more ill, you cannot benefit|
|Funding long-term care needs||Giving all your pension fund to an insurer will leave no money to fund long-term care so your pension fund will not protect against the risk of needing to pay for care|
|Living much longer than expected||This is the major risk that an annuity DOES protect you against, but you need to live to about 90 before they are good value. Meanwhile, the annuity leaves you open to all the other risks listed above|
So beware before buying an annuity. Check carefully what your needs are and make sure you get the best possible chance of doing the right thing for yourself and your family.