Tens of thousands of middle-aged, middle-income Britons are asking themselves this question right now. They are seeing their parents arrive at retirement and crashing headlong into the wall of declining annuity rates. A combination of increasing life expectancy and declining gilt yields has sent annuities tumbling.
Savers into personal pensions, group personal pensions, and many AVC schemes have to convert their fund into an annuity by age 75 at the latest. Crucially, this rule will also apply to the new stakeholder pensions.
The annuity income a pension can buy has reduced over the past few years.
For example, a man aged 65 with a £50,000 fund could have achieved an annual income of just over £5,060 in January 1998. By January this year, the same fund could buy £4,456 – a 12% fall.
Today’s annuity dilemma will be shared by tomorrow’s retirees. Life expectancy is improving – the average man aged 65 can now expect to live until he is almost 84, two years longer than was projected a decade ago. A 65-year-old woman can expect a further 22 years, a 16-month increase. This means annuity rates will continue to fall, as a lump sum has to be spread over longer retirements. The annuity dilemma is best illustrated with an example.
Take a man, just turned 40 and planning retirement at 60. He needs to save, but is not sure which is the best option. He decides to save an extra £200 a month. One choice is to invest this into a personal pension, knowing his contribution will be boosted by the government thanks to income tax relief at his highest marginal rate.
So for a basic-rate taxpayer, the £200 net contribution is grossed up to £256.41 a month (using the 22% rate from 6 April this year). For a 40% taxpayer this rises to £333.33 a month. Legal & General projects that over the 20 years to retirement, this £200 a month net contribution would produce a pension fund worth £119,000 for the basic-rate taxpayer and £156,000 for the higher-rate taxpayer. This is based on its standard personal pension, one of the lowest charging contracts currently available.
The larger fund would produce a maximum tax free lump sum of £39,000 and a gross annuity of £9,640 per year. The basic-rate taxpayer would have a lump sum of £29,900 and £7,400 per year. The annuities contain no guarantees, no spouses’ pension and no index-linking. They are based on current PIA-authorised projection rates. If our example was female, annuity income would be lower due to longer life expectancy.
The alternative is for our 40 year old to invest the same amount into an Isa. Again, using standard PIA projections, Legal & General forecasts that this could grow into a fund worth £95,540 by the time he is 60.
Investing for income, say into a corporate bond fund yielding 8%, would produce an income of £7,643. However, any income taken from this fund is entirely tax free and the investor is not compelled to purchase an annuity at any time, allowing spouses and family to benefit from the fund after his death.
In the case of the basic-rate taxpayer, the Isa route appears to have the edge. If he foregoes the tax-free lump sum he can boost his annuity income to £9,870, which might produce a net income of around £7,690, depending on other income and future tax rates and allowances. But he might prefer to risk an income from his Isa because others can benefit after his death.
On the surface, the top-rate taxpayer will find it hard to forsake £133 a month in tax relief. This boosts his pension fund ahead of what can be achieved by investing £200 a month into an Isa. If it is all used to buy an annuity, the after tax income would be in the order of £9,770.
However, there is another option. Our investor need not reinvest into the pension the top slice of relief that he claims back through his tax code or self-assessment form. This £76.92 could itself be invested into an Isa. Over 20 years this is projected to grow into a fund worth around £36,500 – or a total pot of £156,500 when combined with the pension fund.
Taking a maximum tax-free lump sum of £29,900, this gives the investor over £65,000 to do with as he chooses plus the security of some annuity income. Invested into a bond fund at 8% this pot would produce £2,920 tax free from the Isa, plus a taxed £2,392. Add in the annuity income and the total income after tax at an assumed 22% is a healthy £10,558.
Obviously, the tax rules on pensions and annuities and Isa are subject to change between now and retirement. But the example does suggest that, given the slump in annuity rates, pensions are no longer the automatic choice.
There are other issues to consider. Money in a pension is safe from temptation.
It cannot be touched until retirement, unlike Isa funds which are available whenever a new kitchen calls. The annual investment limit into Isas is £5,000 a year, or £416 a month, which is a restraint for higher earners.
And Isas themselves are only guaranteed to last for another nine years, though it would be a very brave chancellor who in nine Budgets’ time trashes the tax concessions for existing Isas.
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