Possible Taxation Implications Of Lifetime Capital Protection For Annuities

by Dr. Ros Altmann

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Concerns have been expressed about the possible tax revenue implications of permitting ‘money-back guarantees’ for annuities.

My initial assumption would be that introduction of lifetime capital protection should have a positive impact on tax revenue. This would be for several reasons:

1. Timing:

The current rules only permit capital protection for up to 10 years and the payments must be made in the form of ongoing income. This means that the tax on the remaining annuity payments is only received over the course of the 10 years. However, with the proposal for ‘money-back guarantees’, the outstanding balance would be paid in one lump sum (to allow the estate to be wound up promptly). I propose that this sum would be subject to a one-off tax deduction (similar to that which applies to drawdown) and would be taxable, without going into the person’s estate. Thus, the Revenue would get the tax sooner, which would mean a net positive to the Exchequer.

2. No escape from tax because sum paid will not fall into inheritance tax exemption zone:

With some of the new types of approved annuities (such as the ‘Open Annuity’), if a person dies before annuitising, their pension pot is treated as part of their estate, and may consequently escape tax altogether. If people are encouraged to take a conventional annuity with capital protection, rather than choosing the ‘Open Annuity’, the net tax take could increase.

3. People will be less likely to opt for drawdown, if they have the ‘money back guarantee’, so tax will be received sooner and may be higher.

There is significant evidence that a major reason for people choosing drawdown is the death benefits issue. If this issue could be resolved with lifetime capital protection, many people are likely to choose to annuitise, rather than going into drawdown. This would mean that the Revenue will receive tax on a higher income stream from an annuity straight away (with drawdown, the income level is much lower than from an annuity, so the tax received is also much lower).

Furthermore, drawdown has performed very poorly in the last few years, so the capital sum invested has, in many cases, become smaller and annuity rates have fallen. These two factors mean that the annuity income ends up lower when a person in drawdown finally annuitises, so the tax received would also be lower. If the person had bought an annuity, instead of drawdown, the tax take would be higher.

4. Encouragement of pensions:

It is possible that the Revenue believes introducing ‘money back guarantees’ will encourage people to put significantly more into pensions. They may, therefore, be concerned that they will have to pay much more in tax relief. I think this concern (if it exists) is misguided.

It is true that addressing the death benefits fears should help make pensions relatively more attractive to people, but I do not believe there is any justification for thinking it will have a dramatic effect. The most likely outcome would be that money back guarantees will just help prevent people from reducing their pension savings (which is likely, if the current situation persists). If people stop putting so much into pensions, Government’s whole pension strategy will fail, and I would have thought that anything we could do to encourage people to keep providing for their older age would be useful.

5. This is NOT capital extraction – an annuity must still be bought.

The lifetime capital proposal is not in any way like the proposals for capital extraction. People still have to buy an annuity and are not free to take the capital out and spend it as they choose. This will, therefore, still provide an effective ceiling on pension contributions, and people will not suddenly rush to put huge amounts into their pensions. It could be that officials have not fully appreciated this point and it may be necessary to stress the fact that this is still buying an annuity. It is also no different from allowing those with large capital sums in drawdown to receive a lump sum if they die before age 75. Why should we allow it for rich people who die early, but not for everyone who buys an annuity? This aspect of policy is currently highly inequitable.

6. Lifetime Capital Protection may entail lower annuity income, reducing tax received.

It is possible that the Revenue is concerned that people will still wait until age 75 to buy the annuity and then take the lifetime capital protection, which would imply lower annuity income (about 16% lower according to Prudential figures) and, therefore, lower tax revenue. Firstly, I believe it is much more likely that people will annuitise sooner with lifetime capital protection, so they will annuitise at younger ages and the cost of capital protection will, therefore, be much less. Secondly, it is already possible to buy 5-year or 10-year guarantees, which also reduce the annuity payments, so the net difference is much smaller than just considering standard annuity rates, compared with lifetime capital guarantee rates.