Fixed versus living annuities

There is little difference between the two from a tax point of view, but there’s significant difference on the passing of a retiree.

Traditionally, retirees opted for a fixed annuity which provided them with a fixed income until they died. This meant they did not need to worry about trying to estimate how long they would live and therefore how to allocate pension funds over the years of their retirement.

But while some people still choose to have a fixed income, fixed annuity pension, more and more people are choosing more flexible options.

“The problem with fixed annuities is that the income they pay is often lower than what people were hoping they were going to live on, locking them into a lower-quality lifestyle” says David Lloyd, managing director for innovation at Liberty.

“If anything, their lifestyle will continue to get worse because of inflation.”

One could argue that as you get older you are going to spend less, but generally many people find their fixed income is not enough. “In essence, if the income that gets paid out is more than you thought, you will be happy. The reality is that most people get to retirement and find they cannot live on that income.”

In addition, if they die, they leave nothing to their children as fixed income funds do not get passed on to inheritors on death. There are, in essence, two things that determine how much a life company pays out in retirement.

The first, encapsulated in a fixed annuity, is that the life company invests your money in bonds, where you are getting a bond return, and because other people who are also invested die at various stages after retirement, their pot of money can be spread, resulting in a mortality pick up plus a bond return as an investment proposition.

Alternatively, people may invest in a living annuity. Here, they invest and keep control over their investment. They can switch into the stock market and the funds go to heirs should they die.

Lloyd says, “The problem with this option is knowing how to invest in the stock market and a financial adviser typically suggests investment in funds via asset managers. There is inherent risk in this option. If, let’s say, there is a sovereign ratings downgrade or economic downturn, the stock market could potentially drop, as will the investment value.”

This is a potential disaster for someone who went into the stock market for potentially better returns who now finds themselves at the wrong stage of life to take that risk. A younger person still has some levers to pull in that situation – they can spend less, change jobs or take on more work.

Retirees are least able to withstand these dips – this is the investment conundrum retirees face.

Yet more and more people are opting for living annuities. The risk may be greater, but they just cannot manage on the lower lifestyle option. Trying to manage the risk has become critical to this kind of investment.

Liberty took a long hard look at the conundrum and tried to find a solution which would mitigate the risk inherent on stock market investment

“Our research showed customers wanted a sizeable chunk of stock market exposure but did not want the risk, so we have come up with solutions where we put in a guarantee,” says Lloyd.

Liberty’s Bold Living Annuity is the first linked investment service provider (LISP)-style product to offer a quarterly high water mark return guarantee.

Clients can choose any mix of funds at any time from a broad range of asset managers that LISP-style products offer, with a high watermark guarantee on the returns which that choice generates, says Lloyd.

Bold is a living annuity with a five-year 80% quarterly high watermark return guarantee, which can be stopped or restarted at any time, or rolled over after five years. The return guarantee applies both to income withdrawals and the return after five years.

Bold does not have a 100% guarantee from day one – initially your worst case under the guarantee is a minus 20% return but every quarter-end that your portfolio of funds is showing a new, high, cumulative return, the return guarantee rises. For example, once a cumulative quarter-end return of 25% is achieved, the return guarantee rises so that a negative return isn’t possible. Yes, this does mean there is still some risk, but because there is a rising guarantee, the risk is reduced quickly. This allows you to take more exposure to the stock market than before but at a level of risk you are comfortable with.

From a tax point of view, there is little difference between fixed and living annuities, although fixed generally incur tax on income while living annuities, invested in shares, incur capital gains tax. As it stands now, capital gain, which attracts a lower tax rate, is a better driver of your return than income, Lloyd says.

There is, however, a significant difference between the two on the death of the retiree and here a living annuity is superior. With a fixed annuity, on your death your whole pot disappears while heirs will inherit the funds in a living annuity.

Fees, however, vary from product to product and require some research.

The way Liberty charges for this rising return guarantee is also very innovative. There is a once off fee of 1% (equivalent to less than 0.2% per year) and only if a customers’ portfolio of funds produces returns above 14% a year (in which case the guarantee will have risen) is there a further charge. This performance fee charge is 20% of any return above the 14%.

Lloyd points out that, with regard to Bold, a valuable guarantee by definition is “expensive”. Rather than charge for a guarantee whatever the result, Bold has linked the guarantee to the performance of your fund, allowing clients to only pay for the guarantee as it goes up.

Customers have to decide if guarantees are worth the guarantee charge.

 This article was sponsored by Liberty.


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