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It has become a concern of mine that nearly everybody that I meet outside of financial services believes that you need to buy an annuity with your pension. The media have been fairly good at educating the public on shopping around for an annuity from the open market, but continue to ignore the fact that there are alternatives. So I thought I would tell you what they are, and why they are worth considering.
Back to basics
Firstly, let’s remind ourselves of the basic choices available with a pension from age 55. You are able to take an income from the whole pot of cash you have saved, or you can take a tax free lump sum of 25% (slightly different for defined benefit pensions, but the same concept) and a reduced income bought from the remainder of the pot. In most situations taking the tax free lump sum is better as it can still provide an income but give you more flexibility and you’ll pay less tax.
What is an annuity?
An annuity is basically buying a fixed guaranteed income for the rest of your life with the money in the pension pot. This is a taxed income, and can provide an income to a spouse after death, can be linked to inflation or level, and can have certain minimum guaranteed periods. If money is tight, and you need to know you will never get a penny less than a certain amount, then an annuity is often the best route. The pension provider rarely provides the best annuity rate, so you should make sure you look at annuities available on the open market, as otherwise you will be settling for a lower income for the rest of your life. Also, if you have had any health issues during your life, it is worth seeing if you qualify for an enhanced annuity that will pay you an even higher income.
What’s the alternative to an annuity?
Some more specialist pensions allow what is known as unsecured income. Whilst this might sound scary, once you know what it means, you will see that it is far from that. In a nutshell unsecured income means you leave the money inside the pension, and you draw an income from the invested money. It means you can take the tax free cash, and then leave the remainder of the money invested to continue to grow. You can then choose an income that ranges from 0% to 100% of what you would have got from an annuity (the calculation is slightly more complicated than this, but in reality this is what it means).
Can I take the tax free cash before the income?
Unsecured income allows you to take the tax free lump sum whilst setting the income at 0%, so no income is drawn, and the fund can continue to grow and be invested. One of the criticisms of pensions is that at retirement someone can use a pension lump sum to go on a cruise, but someone younger cannot use it to save their home or business. For the over 55’s this is an option, without dipping into the pot there to provide an income. This could be used to pay off a mortgage or get you out of a sticky cash flow situation, and does not stop you continuing to save into the very same pension.
Can I still buy an annuity?
If you utilise unsecured income either just to access the tax free cash or to draw an income as well, you can still buy an annuity later on. One of the attractions of unsecured income is the ability to vary the income each year. So someone retiring on a phased basis can gradually draw a higher income until they have completely retired. At that point, the comfort of buying an annuity is still an option. This is why unsecured income is a really useful tool for business owners.
Can you defer buying an annuity until interest rates are higher?
At the time of writing, the base rate remains at 0.5%. As a result of this and also quantitative easing annuity rates are at an all time low. Unsecured income gives you exactly the option to defer buying your annuity now. If you believe that interest rates and annuity rates will rise, unsecured income gives you the opportunity to draw an income without committing to an annuity until a time that is right for you. This may also be useful if you aren’t sure which type of annuity would be best for you, for example if your marital situation is likely to change in the future.
What pensions allow unsecured income?
Generally speaking, Stakeholder pensions and company pensions schemes do not allow for unsecured income. Very few personal pensions do either. Generally unsecured income is only available through Self Invested Personal Pensions (SIPP) and WRAP platform based personal pensions (see our previous articles on WRAPs). That said, if you have any of the former, with advice you can transfer your funds into a pension that does allow unsecured income.
I have a company pension scheme, can I still do it?
If you are an active member of a company pension scheme, then you can only transfer to a scheme that allows you use unsecured income if you leave that scheme. Some more flexible employers will allow you to rejoin the scheme, but some will not, so you will need to ask the question to know where you stand. If however you have left the company or are about to retire with that company then transferring to a scheme that allows unsecured income will usually be an option that is available to you. Some schemes (usually defined benefit schemes) won’t let you transfer in the last 12 months before you reach the scheme retirement age, so again be aware and ask the question or seek advice.
What happens when I die?
With an annuity, the answer depends on what annuity you opted for when you bought it. Most commonly this means that your spouse would continue to receive 66% of the income you were receiving and after that the income would disappear, unless you had bought into a guaranteed period. Again, most commonly this means that if you (and your spouse if you have one) die after 6 years, the money all disappears. Using a realistic example, a pot of £100,000 might provide an income of as much as £5,000 a year, but if you died after year 5, you may have only got back as little as £25,000 and the annuity company keeps the rest. Whilst they use this to fund those that live to a ripe old age, wouldn’t it be better if some of that money went to your children instead? When you die during unsecured income the proceeds can be left to whoever you want. They are liable to 55% tax, but in the same example, and assuming you only received 5% growth after charges each year (obviously not guaranteed), your children would have received around £45,000. Even in year 20, and still taking the same income and only getting the same 3% growth each year, they could expect £45,000. That’s nearly half of the starting pot, and something that can help them with their retirement.
What are the risks of unsecured income?
Annuities provide a guaranteed income for life, and that is their attraction. The risk with unsecured income is that your money remains invested in the pension, and so whilst it can provide an income similar to an annuity, if the investment falls, so could your income. If you get it wrong, this could mean you run out of money. That is why your investment choice is so important. A life company managed fund or a ‘with profits fund’ is likely to be appropriate in unsecured income. Getting advice on how to invest the funds is definitely a sensible strategy as you need to try and ensure your investments are not volatile. In the above example, of taking £5,000 a year (5% of the original pot), and getting 5% growth each year after charges, the capital would remain at £100,000, and continue to generate the same level of income. If you only got 3% after charges, the money would run out in year 31. That said, you would have been forced to take gradually reduce the income being taking in this instance as a result of the Unsecured Income restriction, so the funds would have actually lasted longer.
Are there any guarantees with unsecured income?
There are a few options known as The Third Way. These are trying to provide the guarantees of an income for life that an annuity provides whilst giving you all the benefits of unsecured income. Whilst you do pay for the guarantees provided, for the right person they can be a sensible solution.
So what opportunities does Unsecured Income present?
In summary, the following opportunities can be achieved by using unsecured income either as a permanent or temporary solution;
Is there anything that I need to look out for when doing unsecured income?
Some of the older style Unsecured Income contracts pay high commissions and offer poor investment choice. Steer clear of these, otherwise all the benefits will be eaten away in charges, and your flexibility will be restricted by exit penalties. Ideally, aim to work with an adviser that works on a fee basis (see our article on how you can pay for advice). You need to ensure you are investing in a mixture of different types of investments that are appropriate to a risk level that you are comfortable with. You also need to continue to review unsecured income to ensure that you are taking too much income, or that the funds are not being eroded too much. Finally, for smaller pension funds, or where you are only just going to have enough in retirement, unsecured income may not be for you, so seek advice before you rush in.
As you can see, with sensible planning, unsecured income can be a very attractive tool that should not be forgotten by the media. Often the bad news of falling markets, low annuity rates and high pension charges make too good a story to be marred by some sensible alternatives! If you would like advice on your option at or leading up to retirement, please contact us Efficient Portfolio for fee based and personal, truly independent financial advice.