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Finding the third way

Created:

21 July 2008

Written by:

Faith Glasgow

The factors shaping our need for retirement income have changed dramatically over recent decades. We're living longer, for a start. As recently as 1981, women aged 65 could expect, on average, another 17 years of life, while 65-year-old men had 13 years ahead of them. Those averages have risen to almost 22 years and 18 years respectively.

Not only do we have more years in retirement, but we have better health for longer, and greater aspirations as to how we’d like to spend our time. That might involve travel, or study, or new hobbies. It might also involve a continuation of paid work in some form, perhaps reducing the need for a full pension to begin with.

The upshot is that when it comes to financing these years, the traditional form of retirement income - a fixed annuity or ‘income for life’ purchased with your pension pot - now seems increasingly inadequate.

Yes, it provides the certainty of a regular income, but you now need a pretty big pension pot to provide a decent lifestyle on an annuity alone. For the past 10 years and more, annuity rates have dwindled (although they've perked up this year; see Annuities hit five-year high). In the 1990s, a £100,000 fund would have bought an annuity of around £13,000 a year; that has fallen to around £7,000.

Furthermore, annuities are inflexible: once you've committed yourself, that's it - you'll be with that provider, receiving that annuity for the rest of your life, regardless of changing personal circumstances or better rates being offered by other providers. You've also lost any potential for your pension fund to grow through stock market investment.

Worse still, unless you buy an expensive index-linked annuity which rises in line with inflation, you're likely to see your income eroded steadily by rising living costs - which have been hitting pensioners particularly hard in recent months.

The unsatisfactory alternative

The alternative to an annuity, income drawdown, allows you to leave your fund invested and take out a certain amount, capped by law, as a regular income. Income drawdown does address issues of flexibility and it also offers the potential to outstrip inflation through capital growth. But the downsides are the very real vulnerability of your capital to market volatility, and the associated risk that if the fund isn't performing as it should, you might have to live off capital rather than income.

As Billy Burrows, managing director of annuity specialist William Burrows Annuities, puts it: The objective for many retirement age investors will be to arrange an income that has the following characteristics:

• It's sustainable in real terms

• It's available as long as they or their partner are alive

• It does not involve undue risk

• It offers maximum flexibility.

Unsurprisingly, innovative financial services providers have been busy devising schemes that aim, within the existing pension rules, to bridge the gaps between income drawdown and traditional annuities.

Living Time

These schemes fall into two camps. 'Living Time' stands apart from the other options in that it is basically an annuity product, but "cut up into bite-size chunks", in the words of its founder, Kim Lerche-Thomsen. During a 'chunk', which can be for as little as three years but is typically for five, you receive a fixed income at a competitive rate; at the end of the term a Guaranteed Maturity Amount (GMA) is paid out with which to buy a new product appropriate to your circumstances at that point; and so on, until you reach the age of 75. (At that point, like everyone else, you can either buy a conventional annuity or opt for an alternatively-secured pension.)

This means that if, for instance, you have developed diabetes during that time, you can benefit from the higher rates of an impaired life annuity, or if you have lost your partner you can switch from a joint to a single annuity. You can also set your level of income, up to the maximum allowed by the government for income drawdown. Mr Lerche-Thomsen gives the example of two teachers who continued to work on a part-time basis for five years after official retirement, and therefore drew just a small income from their annuity and rolled up the extra during that time. "Alternatively, if you've been given only a short time to live, you can choose to take the maximum income," he adds.

A further benefit is that if you die during the term of the annuity, your estate will receive the full lump sum invested, less any income paid out.

The GMA is calculated at the outset of the plan so as to enable you to continue for the remainder of your life on roughly the same level of income as you are currently receiving. But as Mr Burrows observes, the GMA is ultimately just a lump sum and there is no guarantee that it will buy the same amount of income by the time you come to take it. "If annuity rates have gone down in the meantime, for instance, you will lose out," he says.

The combination of guaranteed income and guaranteed maturity value do ensure that clients know exactly where they are in financial terms. But you can only make changes at the end of each annuity term, so flexibility is relatively limited. And there's no likelihood of capital growth, given the cautious nature of the underlying investments.

The other products on the UK market are effectively guaranteed drawdown plans, where your capital remains in the equity markets with the potential to outstrip inflation in the longer term, the income can be managed to suit your needs and, crucially, there are income guarantees in place to protect you. These are created through the use of derivatives to hedge against falls in the markets.

Most such plans come from the UK offshoots of American firms, where these so-called variable or investment-linked annuities have been available for 15 years and more.

All share the idea of an income guarantee, but each guarantee is different, making it difficult to compare like with like. For example, The Hartford - "by far the easiest to understand", according to Billy Burrows - offers clients a choice of around 100 funds in which to invest their pension pots; the first 10 per cent of growth each year is then locked into the guaranteed value which is used to work out your age-related guaranteed income. It will not go down even if markets fall.

Michael Rudge, managing director of Hartford Life, explains how this works. "A 60-year old would be able to take 5 per cent of his fund as income, which would amount to £7,500 for the rest of his life on a fund of £150,000, regardless of the markets. But this can go up. Say the fund grows by 10 per cent to £165,000, that is locked in; if £7,500 is withdrawn as income, that leaves the guaranteed fund value [on which next year's 5 per cent is calculated] standing at £157,500. If the fund value stays flat, then income stays flat; if the markets fall that's our risk and we hedge against it."

Mr Rudge emphasises that because the guaranteed fund value is in place, it's feasible for clients to hold a higher risk, and potentially higher return, mix of equities and bonds than they would otherwise recommend, further helping to 'inflation-proof' the investment. "Looking back over 10-year periods throughout the last 20 years, on a 60/40 split between equities and bonds, as opposed to the conventional 40/60 breakdown, the average annual 'step up' for the guaranteed fund value, after income has been withdrawn, is 3.4 per cent," he explains.

Variable annuities

The Lincoln i2Live scheme works differently. Simon O'Connor, head of marketing at Lincoln, explains that, based on the size of investment, sex, age and health, a Maximum Supportable Income (MSI) is calculated. You can take up to the full MSI if you're busy having a good time; but if you don't need to, the money remains invested and helps to grow the fund. Gains are locked in every five years.

There is also the important option of a guaranteed income, regardless of how the markets fare. "It's a kind of income insurance, so you can be sure you'll always be able to cover the essentials," says Mr O'Connor. Needless to say, however, that income insurance comes at an additional price.

When you reach 75, the fund can be moved seamlessly into a Lincoln annuity paying out the same amount (or you can choose an annuity with a different provider).

MetLife and Aegon also offer similar third-way annuity products.

The benefits of variable annuities extend beyond a flexible, guaranteed income. If you die, these schemes operate like pension drawdown, in that your estate receives the remaining lump sum less 35 per cent tax (indeed, Hartford offers a guaranteed return of the full original investment).

The trouble is that there's an additional charge. Variable annuities cost much the same as ordinary drawdown plans to set up, but investors have to pay extra for the guarantees involved. Typically this amounts to an annual charge of 0.75 to 1.5 per cent of the fund invested.

Is the extra cost worthwhile? On the one hand, additional charges erode investment performance. Against that, because of the guaranteed income level, investors are able to remain more heavily invested in equities than they probably would in an unprotected drawdown fund, and therefore are potentially better placed to generate additional growth - but without jeopardising their standard of living. "You're basically paying for peace of mind, as you do for any insurance policy, whether or not you need to use it," says Mr Burrows. "I think it's valuable in that respect."

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