A double whammy hits pension incomes

With stock market falls hitting the value of pension funds, investors approaching age 75 now face the dilemma of whether to buy an annuity or opt for the “get-out clause” – the alternatively secured pension (ASP).

The political debate over whether people should be forced to buy an annuity for income has intensified, with the House of Lords due to consider the issue on Monday. The Liberal Democrats are proposing that the age at which a person has to buy an annuity be raised to 85, while the Conservatives believe that the requirement to annuitise should be temporarily suspended to allow pension pots time to recover.

As the rule stands, people who turn 75 will either have to buy an annuity or an ASP. The concept of the ASP was introduced in April 2006 after a Christian group objected on religious grounds to buying an annuity.

An ASP is a form of income drawdown, similar to an unsecured pension (USP), which allows investors to keep their pension fund invested in the stock market beyond the age of 75, but with the risk that they could lose money. This means that, as with a USP, pension money can be passed to heirs. But there are punitive tax charges – there is likely to be a charge of 82 per cent on an ASP, whereas on USPs it is only 35 per cent.

There are also limits on how much can be drawn down from an ASP. Investors can take a maximum of 90 per cent of what an equivalent annuity would buy, and a minimum of 55 per cent, compared with a maximum of 120 per cent in a USP.

However, a USP cannot be maintained beyond age 75. So advisers say there are reasons why a person might want to opt for an ASP. One is that people may not want to tie into an annuity rate with stock markets having fallen so far, as the value of their pension may be less than they had thought. By moving temporarily into an ASP, they could wait for their fund to recover.

But industry experts are now predicting that annuity rates will fall significantly over the next year. Hargreaves Lansdown predicts they will fall below 7 per cent. So investors would have to balance a potentially larger pension pot against the probability of lower annuity rates.

Another reason to take an ASP is if one spouse is considerably younger than the other or if one spouse is in ill health. Buying a joint life annuity would probably mean a low rate, as the payments would have to continue for the life of the younger or healthier partner.

But in an ASP, when the first spouse dies, the pension can be passed to the remaining spouse, who can then use it to buy a new annuity at what could be a better rate.

There are risks to this approach, as well. Nigel Barlow, head of retirement income planning at Just Retirement, warns: “The income you could draw from an ASP might be higher than a joint life annuity, but you run the risk of depleting your fund so that when you die your spouse might not have the same income.”

He suggests people in this position should draw a smaller amount from their pension to ensure it is still there for their spouse. “If you’re concerned about providing a pension for a spouse, drawing 55 per cent will help ensure there is some fund left for them.”

Then there is the mortality drag to consider. “The mortality drag is the extra investment yield you need in order to counter the mortality cross-subsidy that you would have had in an annuity,” explains David Marlow at Alexander Forbes.

“An annuity is an insurance contract which pools people’s money together as some people die sooner than expected. Anyone in an ASP will worry about their investments outperforming what they would have received as an annuity.”

It is this problem that leads some to be wary of ASPs. Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “I think the nature of the mortality drag is such that it will work against you.”

Not all pension providers allow death benefits to be passed down in an ASP, mostly because they fear the government could crack down on ASPs and remove their licences. Aegon Scottish Equitable, Standard Life and Suffolk Life allow death benefits, but Hargreaves Lansdown and Just Retirement do not. For those hoping to use an ASP for death benefits alone, advisers say there is a simpler way: buy a whole of life policy with the income from the annuity.

Simon Bullock, an adviser at Truestone, says: “Annuity rates for a male aged 75 are currently around 8.3 per cent. He could take an annuity from a pot of £1m, pay the tax and then use the net income of around £64,000 to buy a whole of life contract, which would have a sum assured of around £900,000.”

These factors mean the number of people in ASPs is tiny – each pension provider has only a few hundred at most. But these people may be biding their time. There is little chance that the Labour party will change its attitude to annuities, but the Conservatives and the Liberal Democrats would implement a change.