"An annuity is a very serious thing. It comes over each year again and again," wrote Jane Austen in Sense and Sensibility.
Today, the choices that your clients have to make when buying an annuity are just as important, and will affect them for the rest of their lives, and that of their dependants. Once bought, an annuity cannot normally be switched to another provider. As it is a once-and-for-all decision, your client cannot afford to get it wrong.
This is why it is crucial that your client understands all the options that are available at retirement, such as:
- single or joint life;
- lifestyle and ill health annuities;
- the availability of guaranteed periods;
- value protected annuities.
So before shopping around to find the best prevailing annuity rate for your client, he or she will need advice on the shape and timing of their annuity and how their dependants can be protected. Around one in four of the population* is eligible for a lifestyle or ill health annuity at retirement, but only one in 10 currently exercises this option - either out of ignorance or inertia.
By having this discussion with your client, not only will you be demonstrating your knowledge and expertise, but that you will be able to prove to the FSA that you are 'treating your customers fairly.' The Retail Distribution Review is also likely to impose higher standards on IFAs, and you will have to demonstrate higher levels of skill and expertise than other advisers, who will not be allowed to use the 'independent' title.
Why exercising the open market option is so important
The uplift in income provided by a lifestyle (smoking or obesity) or ill health annuity, compared to a standard annuity can be as high as 40 per cent. This extra income could pay for extra benefits, such as a spouse's pension, escalation, a guarantee or value protection. In fact, if your client qualifies for a special annuity, they could be better off, even with all the extra bells and whistles, than if they bought the standard annuity on offer from their existing pension provider.
Your client may well initially opt for a standard, single life annuity, with no escalation or spouse's pension because this will give them the highest possible income at the outset. But it may be worth pointing out to your client that the bulk of today's pensioners who are living in poverty are women over age 85, who either have no spouse's pension, or a modest one, with no inflation-linking.
Single or joint life?
Your client can protect their spouse by buying a spouse's pension for 50%, 66.66% or even 100% of their own pension, which will continue to pay out at this level until the death of your client's spouse.
Either way, a discussion about increasing longevity (for both sexes) will demonstrate the need for your client to consider buying a pension for their spouse and adding some inflation linking to this as well..
A 60 year old man today can expect to live to age 84, and today's 60 year old woman to 87 - ages which are expected to increase to 85 and 88 respectively over the next 10 years,** so your client needs to be prepared for a retirement span of 25 to 30 years. Even today's low inflation rate of 2.5 per cent will halve a fixed level pension over 30 years.
For those clients who fear dying shortly after annuity purchase, it may be worth pointing out to them the option of buying a guarantee which will means that their annuity will continue to be paid for 5 to 10 years after they die.
But annuity guarantees have to be paid in the form of an ongoing income, and cannot be paid to dependants as a lump sum. Guarantees also come at a cost, so your client will have to accept a slightly lower income to pay for the guarantee.
Value protected annuities
Annuitants under age 75 can opt for a value protected annuity which can be attractive to clients who fear 'losing' their pension to the insurance company if they die early.
These so-called 'money back' annuities pay a lump sum to a nominated beneficiary, if your client dies before age 75, without having received full value from their pension fund.
Your client simply completes a nomination form (which can be changed at any time) and chooses the percentage of the fund value they wish to protect. This can be up to 100 per cent of the fund.
Money back (value protected) annuities
A lump sum will be paid out on the annuitant's death to the nominated beneficiary. The amount paid will be the chosen protected percentage of the purchase price, less the total gross income payments made to the date of death, and less 35 per cent tax. Payment can only be made if the annuitant is under age 75 at the date of death.
Payment will be the selected protected percentage of the purchase price, less the total gross income payments made to the date of death. The annuitant can choose to have the value protection lump sum paid immediately upon their death (1st life) or following the death of the annuitant and their dependant (2nd life).
The dependant's pension will continue to be paid at the selected protected percentage of the annuitant's pension, after the value protection payment has been made.
The dependant's pension will be paid at the selected percentage of the annuitant's pension, and the value of the income payments to the dependant will count towards the total gross income payments, in the value protection calculation made on second death.
Your client can nominate whom they want to receive this benefit at the outset, or at any time during the life of the annuity. Your client can also change the nomination at any time by writing to the annuity provider.
The lump sum will be taxed at 35 per cent before it is released to the nominated beneficiary, but it is not normally counted as part of your client's estate for inheritance tax purposes.
Who provides value protected annuities?
Conjuring up extra income for your client
Clearly, joint life annuities come at a price, but if you find that your client is eligible for a lifestyle or ill health annuity, you may be able to provide your client with additional income for their spouse, without your client suffering a lower income. Your client could even be better off!
Value protection allows your client to obtain full value from their annuity, albeit with 35 per cent tax deducted, and providing the annuitant dies before age 75. This can provide your client with considerable peace of mind and may be appropriate if your client:
- does not expect to live beyond age 75;
- has a very large pension fund; and, or
- has a spouse with little or no pension of their own.
Even if your client does not require any of the bells and whistles described above, by discussing all the options available at retirement, you may well discover other areas of financial planning on which your client requires advice.
Other areas of retirement advice which your client may require could include with profit and unit-linked annuities, unsecured or alternatively secured pensions, phased retirement, equity release, long term care, will writing and inheritance tax planning.
In any event, you will have shown that you are treating your customer fairly - an area of compliance which the FSA will be focusing on more closely throughout 2008.
** Continuous Mortality Investigation Bureau July 1999