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Thursday, 25th April 2024 |
| Solutions to the ‘annuity question’ |
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| Joe Byrne provides a comprehensive list of suggestions on how to overcome the (euro-induced) problem of slumping annuity rates. |
The slump in annuity rates over recent years which has arisen primarily due to Ireland's entry into EMU, is just one of the pitfalls facing those who retire.
For those who have accumulated pension fund assets in defined contribution schemes or personal pension plans over the last twenty years, the annuity remains the only mechanism for converting one's accumulated pension fund assets into lifelong income.
The purchase of an annuity at retirement provides a stream of income payable for life and perhaps continuing for the lifetime of the surviving spouse or dependant which is guaranteed to remain at a certain level or to increase annually at a prescribed rate. By buying an annuity, the pensioner is not exposed to the longevity risk (i.e. the fund available may run out before the pensioner and the dependants die) nor the investment risk (i.e. the return on the fund proving insufficient to sustain the required level of retirement income).
Annuity costs have risen by 37 per cent since 1995 as interest rates have fallen in the run up to EMU. Clearly, this, among other factors, has been a cause of much concern:
(a) Pensioners feel that there is a lack of choice with regard to the institutions where annuities can bought.
(b) Long bond yields are currently approximately 4.4 per cent and annuity rates are not much higher.
(c) Life assurance companies are offering poor value for money due to lack of competition.
(d) Pensioners are forced to purchase an annuity at the point of retirement in a 'once-off' investment decision.
(e) Pensioners feel that they have lost access to their capital once their accumulated fund at retirement is used to purchase an annuity.
Having regard to the 1999 Budget one would have to conclude that in an ideal world the desirable features of any system would be as follows:
l Widening the number of annuity providers,
l Providing more consumer choice,
l Offering security of income,
l Maximising retirement income,
l Involving capital preservation where possible,
l Offering flexibility to adapt to change, e.g. serious illness.
So, where could possible solutions be found in the current environment?
Consumer choice
In order to overcome some of these problems, there is a need for greater consumer choice for the pensioner. However, greater consumer choice can also lead to difficulties and the potential for the mis-selling of annuity products.
It is essential, therefore, that the consumer can have access to appropriate advice and is aware of the risk that he is taking on. It is not possible to find a solution to answer all the problems with annuities. Traditional annuities have served the pension community well in that their primary intention was to provide retirement income without risk. The accumulation of wealth and the protection of capital are separate issues.
Lower pension payments
As interest rates have fallen, annuity payments have reduced. Higher retirement income can only be achieved by taking a more aggressive approach to the investment of funds in retirement but this would necessitate the pensioner taking on additional investment risk which may not be appropriate in certain circumstances. For example, many years ago a person retiring at age 65 meant that his accumulated pension assets over say the previous 40 years had to last a retirement of perhaps 10 years.
Nowadays, pensioners are retiring earlier and their accumulated retirement savings have to last for periods of up to 25 to 30 years in retirement. Therefore, the traditional fixed income approach may not be fully appropriate in certain circumstances. In all circumstances, it is difficult to but not impossible to protect capital or otherwise the level of pension income will be low.
Lifestyle investment strategies
The development of lifestyle investment strategies for defined contribution pension products and the introduction of PRSAs which are also likely to have a kitemarked investment mandate along similar lines will reduce the effect of sharp falls in interest rates near retirement and the consequent increase in annuity costs. Current retirees have been partially compensated for the recent interest rate falls through the strong performance of investment markets in the last five years. It is essential that future pensioners are made fully aware of the importance of investment strategies in the years leading up to retirement.
Risk and reward
In order to generate additional investment returns for pensioners in retirement, one will have to look at pensioners taking on additional risk.
l In an EMU environment, traditional annuity providers may be able to generate higher yields from other fixed interest stocks with higher ratings, for example corporate bonds or strip gilts.
l Were the Irish Government to consider introducing a greater amount of index linked stock, then index linked annuities could be made available. However, index linked stock are scarce in the Euro market.
In view of the long periods for which retirees will be drawing a pension, it could be advisable in the long term to allow younger annuitants to take on some investment risk by having a mix of gilts and equities. Two ways to achieve this are:
- With profit annuities, or
- Unit linked annuities.
With profit annuities allow annuitants to improve their income by taking an investment risk and avoiding the need to rely on the return on long term stocks as the foundation of future income.
Under with profit annuities, income is based on the level of bonuses declared from year to year. These bonuses depend on the investment terms of the underlying assets and hence are not known in advance.
With unit linked annuities, the accrued pension fund may be invested in a range of unit linked funds and units are sold to provide income, which is therefore dependent on unit prices. The annuitant thus has access to equity investment which traditionally performs well over the long term. However, poor stock market performance will result in a fall in income and the initial income is less (about 30 per cent less) than that earned from a conventional level annuity. This is partly because the life office charges for fund management in addition to its normal charges which are not applicable with conventional annuities.
Both these products to some extent allow the life office to take on the mortality risk while the pensioner takes on the investment risk. These products have not been popular, because the initial pension amounts are low even though they might be higher in the long run.
Further options to be considered are as follows:
Deferral of annuity purchase
This allows flexibility to allow retirees draw their tax free cash at retirement but defer purchasing the life annuity at any time up to age 75. This will allow pensioners to choose when the annuity could be purchased and not to be totally dependent on market conditions on any one day.
Purchase of temporary annuities
Ther option allows the purchase of temporary annuities for up to five years before buying an annuity for life. Essentially, this would be like investing in a five-year cash or gilt fund with full capital return at the end. This approach is unlikely to improve the retirement income but does give greater freedom of choice. Such an arrangement, however, may be appropriate for someone in very poor health where the capital protection is paramount.
Lifestyle funds
The use of lifestyle funds where a kitemarked plan automatically switches from equity type investments into gilt investments prior to retirement will offer additional protection.
Income drawdown annuities
Income drawdown annuities can enable individuals to defer having to purchase conventional annuities at retirement when it could be a poor time to purchase an annuity. They can allow exposure to equity type assets which should increase the level of the conventional annuity when it is eventually purchased. They allow pensioners flexibility to vary annuities.
Safety net product
An alternative approach would be to allow individuals to take their tax free cash and as a basic minimum pension a fixed annuity of say IR?8,000 to IR?10,000 per annum.
Any remaining funds can then be applied to an income drawdown product to be invested more freely if the individual desires. Income drawdown could be permitted on an indefinite basis but subject to minimum and maximum limits similar to the UK to avoid tax abuse. On death, the remaining fund (if any) can be paid to the individual’s estate subject to a tax charge.
Capital guarantees
In order to protect capital, individuals should give strong consideration to purchasing a ten year guarantee on their annuities where possible. This course of action will give greater protection against early death at low cost. The Revenue need to look at the current rules in this regard in order to give retirees increased flexibility.
The Revenue should also consider extending an option to self-employed retirees to purchase tax free life assurance at the point of retirement as part of their retirement annuities.
Domestic property equity release
Another approach which has been used to generate income in retirement in the UK is equity release mechanisms from private property. With the increase in property values in Ireland, one will find in future years that there will be many people with limited income and a valuable house but with few other assets. In the UK, people have looked at ways of releasing some of the equity in their house.
Under these schemes, an institution pays the owner of the property an income for life in return for a cash sum from the sale proceeds of the house after the owner dies. The owner has rights of residency in the property for his lifetime. Such schemes could become popular in Ireland if they were structured carefully and properly designed to protect both parties. Such schemes could well turn out to be an important source of retirement income in years to come.
Traditionally, pension annuities were not considered to be vehicles of investment, but rather a means for survival. Fundamentally, this should not change, but for the higher socio-economic groups and for those with large accumulated pension fund assets the investment element of annuities will come under closer scrutiny. Annuitants will look for higher returns for their money. Legislation permitting, annuity deferral will develop from this as annuitants gamble on the best time to purchase their annuities.
Long term care which may be associated with pension provision in future years. Evidently, as pension fund assets build up and as people are living longer, then retirement planning is becoming more complex.
In order to generate additional returns on accumulated pension fund assets and to avoid the once-off annuity purchase decision, there is a need for some additional annuity products including a draw down annuity. These products will need to be:
l standardised/kitemarked,
l operated with tight controls to protect the consumer and the Revenue.
l approved by the Revenue in order to avoid tax abuse,
l relatively straightforward so as to avoid the cost of professional advice during the course of the annuity,
l transparent.
l able to provide for the balance of the fund on death to be paid to the deceased's estate subject to tax as if it had been paid as income.
I would also suggest that on retirement, individuals could take their tax free cash and as a basic minimum pension a fixed annuity of say IR?8,000 to IR?10,000 per annum.
However, it should be borne in mind that the average payment currently being made to purchase annuities is around IR?50,000 leading to an average annuity without increases of around IR?4,000 per annum. Creative investment risk products will only be appropriate for the larger annuity purchases. |
Joe Byrne is group actuary/deputy managing director at the Employee Benefits & Investment Division of Coyle Hamilton. This article is based on a recent address to the IAPF.
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| Article appeared in the April 1999 issue.
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