New Annuitisation Rules – the good, the bad and the ugly

by Dr. Ros Altmann

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The Good

People can stay in drawdown beyond age 75. The changes will also benefit people who want to remain in income drawdown arrangements after age 75, rather than having to buy an annuity.

Wealthiest pension savers can get cash out of their pension funds whenever they like. The reforms are brilliant for the very wealthiest pension savers. People with huge pension funds can get their money out whenever they like, once they have secured the Minimum Income Requirement of £20,000 a year – which would usually mean buying an annuity with about £250,000 of their pension fund, but then being free to do what they like with the rest, subject only to income tax rates – or if they are non-resident they can take the money tax free.

Tax cut on inherited pension funds for wealthiest over 75s. Those who do not annuitise by age 75 will benefit from a huge tax cut when passing on unused pension funds. Currently, the tax rate is 82% (70% on the pension plus 12% Inheritance Tax) but this is being cut to 55% in the new regime.

Money back annuities after age 75. People will be able to buy ‘value protected’ annuities – which are basically annuities with a money-back guarantee. These annuities will pay back any unused amounts from the pension fund, if the purchaser dies before having received payments equivalent to the value of the initial purchase cost of the annuity. This will help overcome one of the big objections to annuities, which is that anyone who dies soon after taking out the annuity will have wasted their pension fund. Even with a ten-year guarantee, the full purchase price is not recovered. With a money back guarantee, the purchaser will get back the full value of their pension fund. Currently, it is only possible to buy a value protected annuity that lasts until age 75.

The reforms may encourage transfers out of final salary schemes. If top earners want to be able to take out cash, instead of having the pension income from their final salary scheme, they may decide to transfer out. The money transferred can be passed on to heirs, with a maximum 55% tax charge on death, whereas a final salary pension will only continue being paid to a partner and, if there is no partner, it may simply cease being paid on death. So, people may decide to transfer out of their company schemes in order to benefit from that money – and this could actually help the funding of some schemes.

These reforms could help the pension tax regime to incentivise long-term care. For the wealthiest pension savers at least, once the MIR is met, residual savings can be taken out at any time to cover care needs. Perhaps we can build in some contingency for this in the legislation, allowing pension funds to be convertible into long-term care funding or insurance options, with tax incentives. This could help avert the looming care crisis, which will inevitably follow our pensions crisis as the ageing population reaches older ages. The Government says it will wait for the Dilnot Report into long-term care funding next Summer, before addressing this issue.

The bad

The tax cut for wealthy over 75s is financed by tax hike on less well-off who die early. Because the Treasury stipulates that HMRC must not to lose any tax revenue, the less well off will have to pay more tax, to offset this tax cut for the wealthiest. This is a transfer of wealth and tax benefits from the upper middle to the very top of the income distribution. At the moment, the tax rate on pension funds left at death before age 75 is 35%. This tax rate is increasing from 35% to 55%. These are likely to be people who could not afford to leave their pension funds untouched and, therefore, not the very wealthiest pension savers. These middle class pension savers face a large tax hike in order to allow a tax reduction for those who can afford not to use their pension funds at all because they have other sources of income to live on.

These measures are irrelevant for the vast majority of pension savers. Average annuity purchasers have just £30,000. 450,000 people every year buy an annuity and less than 1% of them have funds above £100,000, so less than 1% of these pension savers would benefit from flexible drawdown. For those top few, however, the benefits are substantial. Not only will they be able to take money out of their pension funds, they also face substantial tax cuts from the current level of up to 82% tax on death for pension assets that have not been annuitised by age 75, down to a maximum of 55%.

The reforms may worsen annuity rates. If more wealthy people annuitise to secure the £20,000 annual Minimum Income Requirement (MIR) at younger ages, annuity rates could worsen for everyone. Someone in their late-fifties will be allowed to take out their pension fund in one go at any time, as long as they have secured the MIR, which may lead to more people in their fifties and sixties buying annuities up to the MIR, in order to be able to access the rest of the money in their pensions. This would add to demand in the annuity markets and could lead to worse annuity rates.

The following table is a summary of the changes. It shows the benefits in terms of lower tax and much greater flexibility for those who can afford not to annuitise or who have pension fund assets higher than needed to secure the Minimum MIR. The Table also shows the tax increases for those in drawdown who die early.

TAX RATES ON PENSION FUNDS ON DEATH

	Current regime Tax rate paid on death	New regime Tax rate paid on death
Before age 75 Drawdown/Unsecured Pension Value protected annuity Leave pension fund untouched Money withdrawn above MIR Lifetime annuity	35% 35% tax free not allowed no fund to pass on	55% 55% tax free 55% no fund to pass on
After age 75 If no annuity bought (ASP) Money withdrawn above MIR Value protected annuity Lifetime annuity	82% (70% tax+IHT) no tax free cash not allowed not allowed no fund to pass on	55% 1/4 tax free cash 55% 55% no fund to pass on

The ugly

55% tax relief recovery charge is penal for those who only had basic rate relief. A ‘tax relief recovery charge’ of 55% is far too high a rate for basic rate taxpayers and takes away much more from their pension than was received in tax relief. The Government admits that perhaps a quarter of those potentially affected by the drawdown regime may have received only basic rate relief on most of their pension savings. However, it has chosen to ignore this. Top rate tax relief gives £2 for every £3 people invest in a pension, which is a 66% benefit. However, those on basic rate relief get only 20p for every 80p they invest, a 25% uplift. Thus a 55% recovery charge is draconian and is far worse than the current 35% tax rate on drawdown.

The measures ignore the most pressing problems for the majority of pension savers. The pensions crisis is hitting the middle and lower earners very hard, they are not being well served by the current annuity market and the open market option is not working adequately. These measures prolong the problems of the current market. They are focussed on the top end of the income and wealth scale, but a radical overhaul of the annuity sales process is far more urgent. Spending legislative time on the top few thousand pension savers is fine, as long as we do not neglect the vast majority who are facing an impoverished old age.

Annuities are not a ‘no risk’ product. For many purchasers, annuities could actually be a high risk purchase. They will be locking into a lifelong stream of income, having given away their entire pension savings, and can never change this whatever happens. If they have bought the wrong annuity, they are stuck with it. If they have not covered their spouse, then they could leave a widow or widower penniless if they die quickly. If they only buy a level income and inflation is high, their purchasing power will erode rapidly. Even since 2003, inflation is up by over a quarter, and that is just seven years. An average retirement will be more than 20 years, so buying a level annuity could mean a problem for older pensioners. By offering a standard ‘default’ annuity, of a single life, level annuity, pensioners are being misled into only looking for the highest income, when that may not be the right thing for them. Indeed, if they are entitled to Pension Credit, it may be better for them to go for a joint-life or inflation linked annuity, rather than the highest initial income, in order not to lose out on their benefits. Without advice, people are not being given the chance to realise the dangers of buying annuities and are often misled into believing that annuities are a ‘no risk’ or ‘low risk’ product, when this may not actually be the case. I believe that people should get advice before they buy and should not be offered any default annuities at all. That would mean they have to actually decide what is the best thing to do, rather than being given the easy option of just ticking a box and sending back their form to buy the wrong annuity at a poor rate!

ENDS

Dr. Ros Altmann
11 December 2010