Unsecured pensions versus enhanced annuities

Ever since income drawdown became available in the 1990s, it has been a popular way for clients to access income from their pension funds without having to purchase an annuity.

The opportunity to take up to 25 per cent of their fund as tax free cash, while keeping the rest of the fund invested in the stock market, is clearly attractive and may be appropriate for those clients with large pension funds of £250,000 or more.

Spouse's pension

In addition, the lack of any requirement for your client to buy a spouse’s pension and the facility for your client to pass the whole of their fund (less 35 per cent tax) to their heirs if they die before age 75 is extremely popular.

However, while income drawdown, (referred to as taking an Unsecured Pension since A-Day), offers much flexibility for the sophisticated and wealthy investor, who may well have assets other than their pension fund to live off, taking an Unsecured Pension is not suitable for the majority of retirees.

Critical yields

This is because 98 per cent of people reaching retirement have a pension pot of less than £100,000, with 40 per cent having less than £15,000. A £100,000 fund will buy a 65 year old an annual income of around £7,000, but this income could be 7-8 per cent high if they were eligible for a lifestyle or ill health annuity.

While someone with a £100,000 pension pot invested in an Unsecured Pension arrangement could withdraw a similar amount (£7,000) in year one, the maximum income they could take in subsequent years could well be lower due to stock market falls and high charges.

Cost of unsecured pensions

Unsecured Pension charges will reduce the value of the fund by around 7 per cent in the first year, so your client‘s fund would have to grow by at least 7 per cent in year one - just to maintain its original value.

In addition, your client runs the risk that annuity rates might move against them, if they defer annuity purchase until age 75.

All these factors make Unsecured Pensions a high risk product for anyone who is dependant on their private pension (on top of the basic state pension) for their retirement income, unless they have a very large fund at the outset and can afford to see it halve in value.

Stockmarket and annuity rate risk

Stock markets did just that in the 2000-03 bear market and the credit crunch of 2007 has led to extremely volatile market conditions which show no signs of abating in the near future.

This means that anyone with a £100,000 pension pot drawing maximum income each year, could not withstand a 50 per cent fall in the stock market and continue to take maximum withdrawals. For this, your client would need a fund of at least £200,000, or preferably £250,000.

Fidelity recommends that retirees should not withdraw more than 4 per cent of their fund each month, if they want to protect their capital against inflation and increasing longevity, and to maintain relatively stable payouts.

Critical size of fund

This means that most people, with funds of less than £200,000, should buy an annuity because it is likely to provide them with a guaranteed and higher income for life than an Unsecured Pension.

When comparing the income provided by Unsecured Pensions with annuities, IFAs have traditionally taken the income payable by a standard annuity as the critical yield. However, we would argue that you should be using the yield provided by an enhanced annuity, which could pay up to 40 per cent more than a standard annuity.

With 4 in 10 retirees potentially eligible for a lifestyle or ill health annuity, this is an important factor to consider.

If you assume that the critical yield of an enhanced annuity (paying 14-15 per cent on average), the numbers in favour of an Unsecured Pension for those with smaller pension funds simply do not add up.

Another feature of Unsecured Pensions which makes them appear superficially more attractive than annuities, is the fact that your client has no obligation to buy a spouse’s pension, thereby boosting the amount of income they can withdraw.

Wealthy pensioners live longer

But this is a misconception because the vast majority of individuals taking Unsecured Pensions die after age 75, at which point your client will be required to purchase an annuity anyway, or take an Alternatively Secured Pension.

We know that longer life expectancy is closely correlated with wealth and anyone with a pension fund in excess of £100,000 is in the top 2 per cent of retirees by size of pension fund and arguably more wealthy than the average retiree.

82 per cent tax charge on ASPs

If your client decides to take an Alternatively Secured Pension (ASP), the amount he or she can bequeath to their dependants when they die will be only 18 per cent of the remaining fund - hardly a king’s ransom. The rest of the fund must be used to provide an income for a surviving spouse.

All this means that Unsecured Pensions are far more high risk than most retirees realise and that many of their perceived benefits - namely the freedom not to have to provide a spouse’s pension (before age 75) and the facility to bequeath their fund to their heirs - are far less valuable in reality than they think.

Other downside risks of Unsecured Pensions - namely the risk of stock market volatility, high charges and the risk of annuity rates moving against your client - all need to be spelled out when advising on the relative merits of taking an Unsecured Pension as opposed to buying an Enhanced Annuity.

Uplift from lifestyle annuities

Clients who are smokers, obese or have had a manual occupation all their lives could qualify for a lifestyle annuity, providing an uplift in income of around 10 per cent. 15 per cent of 65 year olds smoke, but only 6 per cent buy smoker’s annuities, which points up the poor take-up of enhanced annuities.

If your client can certify that they have smoked at least 10 cigarettes a day for the last 10 years, they could qualify for a smoker’s annuity, providing an uplift in their annuity rate of around 10 per cent. Your client can even give up smoking after the purchase of a smoker’s annuity, without this affecting their income.

If your client is at least 30 per cent over the normal weight for someone of their age and height and has an associated medical condition as well, they could qualify for an obesity annuity.

Eligibility for ill health annuities

In fact, if your client suffers from any medical condition which could reduce their life expectancy, this could trigger an uplift in income of as much as 40 per cent.

There are 1,500 conditions which could make your client eligible for an ill health annuity, including many common conditions such as type 2 diabetes, heart disease, raised cholesterol, high blood pressure and liver conditions, as well as other diseases such as Parkinson’s, cancer and emphysema.

With 74 per cent of retirees being unaware of the existence of lifestyle and ill health annuities, it is incumbent on you, as the adviser, to bring these options to your clients’ attention, particularly as the FSA steps up its scrutiny of IFAs’ compliance with the Treating Customers Fairly requirements.

2008 will see the FSA stepping up its activity in the TCF area with an end March 2008 deadline for firms to show that they have taken steps to incorporate TCF into the business practices, with a final deadline of end 2008 to show full compliance.

Last edited December 2007