Despite the wide range of annuity options available on the market, many employees still fail to shop around to obtain the best deal, so should employers be obliged to help them, asks Ceri Jones
The advantages of shopping around for better annuities hit the headlines in May this year when the Pensions Regulator demanded an improvement in the level of knowledge and practice shown by employers when it comes to helping retiring employees understand the types of annuities and drawdown options available to them.
On reaching retirement, members of defined contribution (DC) schemes usually have to use all or part of their pension pot to purchase an annuity. This is a contract between an individual and an insurance company under which the latter agrees to pay an income to the member for the rest of their life.
For years, most DC scheme members have simply taken the annuities on offer from their existing pension providers, but by not shopping around they can end up with significantly lower annual payout rates.
However, since 2001 insurance companies have been obliged to tell policyholders they are free to buy an annuity from an insurer of their choice. This is known as the open market option. In theory, they must communicate this at four months and six weeks before the employee’s retirement dates, but many retirees still fail to shop around. To tackle this issue, the regulator has suggested employers and trustees of trust-based DC schemes offer one of three levels of service. These are a default option selected by the trustees, access to a financial adviser, and a link with an annuity broking operation to enable individuals to compare schemes. The latter is likely to be the most popular solution.
One concern is that so many types of annuity are now available. Enhanced rates are routinely available for people who smoke or are overweight and some providers also take members’ postcodes and occupations into account because these can provide indicators of life expectancy.
Dependants’ pensions are another thorny issue. One third of married people take a single life annuity which will not pay anything to a surviving spouse, rather than a joint life plan that continues to pay out until the second person in the couple dies. Helen Dowsey, principal in benefits solutions at Aon Consulting, says employers should have robust systems in place to ensure the difference is clearly communicated so that they do not have to deal with any comeback from disgruntled partners.
Other options, including variable annuities and income drawdown options, may appeal to wealthier retirees who want to continue to have some of their money invested in the stock market. This is a complicated decision which means looking at a person’s financial situation in the round.
One approach for employers is to provide access to modelling tools which enable staff to enter various assumptions into a computer and compare the incomes generated. “To put in place a process for the handful of members who are retiring this year may seem onerous but the numbers will grow significantly in the future,” says Dowsey.
Having a framework in place to help staff make retirement decisions is important. Gary Smith, senior consultant at Watson Wyatt, says: “This would ideally include pre-retirement education and support, starting around five years before retirement and blending into more detailed help as members move to within a couple of years of retirement.”
But providing advice can be costly, and if this cost is passed on to employees it could be prohibitive. Eddie McGuire, corporate development executive at JLT Benefit Solutions, says: “Some 90% of people in DC schemes have £50,000 or less in their funds and the cost of independent advice doesn’t stack up at that level, so more often than not people roll over into annuities with their existing company.”
Gordon Simpson, senior consultant at Punter Southall Financial Management, says employers should treat staff in DC schemes the same and not provide more support around annuities to those in trust-based pension schemes than in contract-based plans.
Selecting an annuity has become even more challenging in the present economic climate. Hargreaves Lansdown, for example, estimates annuity rates could drop by more than 7% over the next 12 months. This, and recent proposals from the Conservative Party, have prompted the government to announce it is looking at the rules around using any uncrystalised pension funds to purchase annuities at 75 years of age.
If you read nothing else read this…
- Staff who belong to a defined contribution pension usually have to purchase an annuity at retirement in order to take up their pensions.
- The annuity market has developed rapidly, with new products compounding the difference that shopping around can make to employees’ income in retirement.
- The Pensions Regulator has suggested employers tackle the issue, for example, by providing the facility for staff to compare different annuities.