Your IndustryMay 7 2015

Traditional ways to generate retirement income

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Alistair McQueen, head of policy and compliance business protection at Aviva, says the UK has one of the oldest, yet most complex, state pension systems in the world. Recognising this complexity, the government is introducing a new single-tier state pension in 2016.

This will provide a maximum income of around £150 per week, which Mr McQueen says creates a clear and ongoing foundation on which all additional saving and retirement income can be built.

Final salary

For a fortunate few, he says a final salary pension scheme has been the other valuable source of retirement income. Around half of those retiring this year have a final salary entitlement of some form, but numbers will fall as few schemes outside the public sector are taking on new members.

As the label suggests, Mr McQueen says if a client has saved in a final salary workplace pension scheme their retirement income from this source will normally be a percentage of their final workplace salary, and will pay for the rest of their life.

He says the risk and responsibility to pay this payment sits with the sponsor of the workplace pension – normally the employer – not with the individual.

Money purchase

Increasingly most of the employed part of the nation in recent years has found themselves with a money purchase, or defined contribution, pension.

At retirement with these schemes, the amount that has been saved in this money purchase or defined contribution pension can then be converted into an income.

James McLeod, head of pensions at AES International, says for those who have defined contribution pension arrangements in addition to state benefit the choice has been between securing a pension using an annuity or taking a greater degree of risk, in particular so far as ongoing investment is concerned, by going into drawdown.

Annuity

An annuity has traditionally been the dominant form of generating a retirement income.

Aviva’s Mr McQueen says an annuity allows the saver to hand over their pension fund to an annuity provider, and in return the annuity provider will pay the saver a guaranteed income for the rest of their life.

He says: “A strong attraction of the annuity is the certainty it brings. For as long as the client lives, the annuity will keep paying. This payment is unaffected by what is happening elsewhere in the economy.”

Of course, most annuities also don’t take account of what happens with inflation so the income stream loses value. Policies that are index-linked tend to offer lower rates and most won’t pay out the amount invested for 20 or more years; rates have been in the decline across the board, too.

Mr McQueen adds: “A potential downside of annuities is that, if the annuitant changes their mind, they don’t currently have the ability to get their money back once it has been handed over to their annuity provider.

“It is a once-in-a-lifetime decision. Also, if the annuitant dies in the early years of payment, there will often be no entitlement for the annuitant’s estate to get a refund of any unspent money.”

On this last point, it is possible to purchase a joint annuity at outset or to buy a policy which guarantees payment for a number of years. Following an easing of restrictions, this guarantee period is now unlimited and subject only to provider pricing.

With a joint annuity, if the primary holder of the annuity dies their dependent will continue to receive an income for the remainder of their life.

Income drawdown

As an alternative to an annuity, the customer can traditionally use what has been referred to as ‘income drawdown’. This allows the saver to take withdrawals from their pension pot over a period of time.

Prior to 6 April 2015, the level of withdrawals came with strict government controls. Since 6 April 2015, however, these restrictions have been lifted.

If the underlying pension product permits, Mr McQueen says the customer is now free to take however much they want, whenever they want.

He says: “An attraction of this approach is that the individual can keep the majority of their pension invested, thereby ensuring it benefits from potential investment growth. This approach also brings with it much greater flexibility, to reflect an individual’s changing needs.

“The potential downside with this approach is that it brings with it none of the lifetime guarantees inherent in the annuity. If using drawdown, the money will only last as long as the individual allows it to.

“If the individual withdraws all their money too soon, there will be no back-up system.

“The fact that the money stays invested in the underlying pension also carries risk. It is true that the underlying pension fund could grow, but it is also possible that it could fall in value if the associated investment falls in value.”