Great news for your pension!

At last, one of the biggest problems with pensions could be resolved by the new government coalition.

Last week, the new Conservative/Lib-Dem coalition thrashed out its agenda for pensions. Although much of it was fairly predictable, it’s great news the two parties are seeing sense on one particularly thorny issue: annuities.

Why are annuities important?

An annuity converts your pension pot into a guaranteed income for life. When you buy an annuity, the amount of income you’ll receive will be determined by prevailing annuity rates at that time. This income will be paid for as long as you survive.

For many of you, buying an annuity at, or around, normal retirement age is the most appropriate way to fund your retirement.

But for others, it's not - and yet, at the moment, you are forced by law to convert your pension pot into an annuity by the age of 75.

Now, under the new coalition, this law looks set to be reformed. This is great news for your pension, for the following reasons:

Related goal

Get ready to retire

There are a lot of things to think about as you get closer to your retirement. But the early you start to prepare, the better.

Do this goal

1) Early death

One of the current, major problems with annuities is the fact that once you die your income immediately stops - unless you have paid extra for a ‘joint life’ annuity which provides benefits for your spouse after your death, but this will reduce your own level of income while you're still alive.

It's a difficult choice. You can either play safe and sacrifice some of your income while you're alive, or take a higher income but risk a situation where, if you’re unfortunate enough to die shortly after buying your annuity, your loved ones will lose most of the value of your original pension fund.

For example, let's say you have a pension worth £100K at retirement which you sacrifice to an annuity provider in return for a fixed annual income of £6,250. If you die two years later, you would have received a total of £12,500 from your annuity, but the balance of your pension pot - that is the remaining £87,500 - will be kept by the provider. Under current rules, it can’t be passed onto your family as part of your estate.

That’s years of saving down the drain simply because you didn’t survive long enough to reach normal life expectancy. For this reason, the obligation to buy an annuity by the age of 75 was so off-putting for many savers that they turned their back on pensions entirely.

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2) Hobson’s choice

A second problem with compulsory annuitisation is that it forces you into buying a product whether you want it or not. Right now, for example, those approaching 75 now will be obliged to apply for an annuity at a time when rates are have fallen to historic lows.

Remember, the level of income you receive is directly related to annuity rates, and when rates are low annuity income drops. In 2009 alone, annuities for both men and women age 65 fell more than 10%, according to lovemoney.com partner, Moneyfacts.

The prospects for annuity rates going forward don’t look particularly good. The Bank of England’s attempt to kick start the economy through its quantitative easing programme has kept gilt yields artificially low and this, in turn, has had a negative impact on annuity rates. Likewise, increasing life expectancy has also put downward pressure on income from annuities.

It’s true rates do become more generous the older you are - simply because the annuity will pay out for a shorter period - but clearly now is not a great time to buy.

What is the coalition doing about annuities?

The coalition has pledged to scrap compulsory annuity purchase at the age of 75.

What does this mean for you? Well, we don't know the details yet, but it's likely that you won't have to buy an annuity at the age of 75 if, for example, you'd prefer to keep your pension invested in the stock market.

There is hope that this means you will be able to pass on more of your pension savings to the next generation of your family, as well as your spouse. But, as yet, there are no clear rules on the inheritability of pensions under the new framework.  

What is certain is that, when compulsory annuity purchase at 75 is scrapped, you will have more control over your pension. If you want to hold off until annuities rates have improved this will become possible under the new rules.

For a rundown of the other key changes, read How the new government will affect your pension.

What is actually going to happen?

This is the $64,000 question and, at this stage, it’s very difficult to predict what the finer details might look like.

Some pension experts have suggested that while compulsory annuitisation at 75 will be scrapped, it could simply be put back a few years. But I hope the new rules will be more far-reaching than that.

By removing the obligation to buy an annuity, you’ll be given more flexibility. This may allow an opportunity to draw directly from the pension fund, rather than buying an income via an annuity, which at this time, will likely lock you into appallingly low rates.

That said, the government has voiced concerns that by having more control over the distribution of your own pension fund, you could deplete your savings too early leaving no choice but to rely on the state for support.

For this reason it may be the case that annuities will remain compulsory if you're likely to fall back on means-tested state benefits during your retirement.

But only time will tell...

What can I do in the meantime?

What if you're going to turn 75 in the near future and don't want to buy an annuity? What can you do? The good news is, under the existing rules, it’s already possible to avoid annuities by using what’s known as Alternatively Secured Pension or ASP.

An ASP arrangement allows you to keep your pension fund invested while drawing an income from it beyond the age of 75.  But this is by no means the perfect solution either.

On death, ASP is effectively taxed at a rate of 82% on any remaining funds passed onto anyone other than your spouse. That means, the treatment of ASPs on death isn’t significantly better than annuities.

It’s also problematic that ASP only allows you to draw an income of between 55% and 90% of the income provided by an equivalent annuity for someone age 75. In other words, the maximum income allowed under ASP is actually less than an annuity.

On top of that, ASP involves a degree of risk since the plan remains invested, and they're really only suitable if you have a large pension fund and aren’t risk averse.

Overall, as a way of avoiding annuities, ASP won’t be an effective solution for most of you. And that's why I think axing compulsory annuities is the best way forward. But what do you think? Is it a good idea? Should the Government be helping pensioners in this way? Share your views and opinions using the comments box below!

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