‘Money Back Guarantees’ for Annuities
by Dr. Ros Altmann
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Why isn’t everyone in favour of offering this lifetime capital protection for annuities? The ‘money back guarantee’ would significantly alter the perception of the annuity market, and encourage more people to put money into pensions. People have lost confidence in annuities and one of their principal concerns is that they will lose their capital on early death. They do not want to lose their hard-earned savings, if they are unlucky enough to die soon after annuitising. If they have the option to buy a ‘money back guarantee’, this would pay to their heirs any balance of the original capital sum which they had not already received as annuity income (after appropriate tax was deducted). This could be a ‘win-win’ situation for everyone. The perception of annuities would improve, the Revenue would get its tax back sooner and people would be happier to put their money into pensions. It seems a shame that not everyone is enthusiastic about the idea. After all, we already effectively allow the rich to do this in drawdown – they can pass on the whole of their capital to their heirs if they die before age 75 – so isn’t it fairer to allow it for everyone? At a conference last week, some of the arguments against providing this lifetime capital protection were presented. I will outline these and offer my comments as to why they are not valid or sufficient.
1. People already have some protection, so why do they need more?
This protection is in the following format:
a. They can take 25% as a tax free lump sum and pass this on to heirs, if desired.
This is true, but people do not see this as nearly enough. The ability to take the tax free lump sum is often the major reason why people feel it is worth putting money into a pension at all. The value of tax relief is not always enough to justify locking money into a pension and is one of the few advantages that pensions have over ISA’s. People often want to spend the lump sum on something particular and, if they die the next week, they will still lose the other 75% of their capital sum. Just telling them they can keep a quarter of it is not enough.
b. They can take a 10 year guarantee.
The 10 year capital guarantee rules require that the heirs must continue to receive a stream of income for the whole 10 years, which means that the estate cannot be wound up until the end of this 10-year period. This is very unpopular. Our proposal of allowing the sum to be paid straight away, not as continuing income, would be much simpler. The Revenue would get its tax sooner, the estate could be wound up promptly and people would feel that the system was fairer.
There does not appear to be any rationale for the choice of 10 years as the limit (I believe it was something to do with copying practices of some DB schemes). Also, a few years ago, allowing 10 year capital protection meant that the person could effectively receive the full value of their capital sum back – or even more than this – since annuity rates were high enough to ensure that the full sum was paid out before 10 years had expired. As rates have fallen so low, this is no longer possible, but allowing lifetime capital protection would not do anything new in terms of repaying the capital sum. The really new feature would be allowing it to be paid as a taxed lump sum. (I would recommend that the sum should be taxed before it is passed into the person’s estate, so that it cannot escape inheritance tax.)
c. Even today, people can buy separate term assurance, if they want to insure against dying early.
Although, in theory, you can buy separate life assurance, in practice this would not be possible in a cost efficient manner. As far as I can see, tax rules mean that the life assurance part would have to be transacted outside the pension tax regime. The insurance policy and the annuity would be treated as ‘related policies’ (under Section 263 of the 1984 Inheritance Tax Act.) This would result in the life policy representing an eligible transfer for inheritance tax purposes and being counted as part of the person’s estate if they die within 7 years. In addition, FSA rules probably mean that the annuity and the life assurance could not be tied together, in the way they would be for lifetime capital protection. Why should people be forced to do this in a complicated, inefficient manner, rather than doing it directly and more cheaply?
d. If in drawdown, people can pass on the residual fund with 35% tax, if they die before they annuitise.
This argument effectively says that it is fine for those with large capital sums to protect their capital (at least to age 75) but not for everyone to have the option to do so! Why should we give a benefit for the rich which is denied to the rest? The Revenue have already set the precedent for allowing lifetime capital protection by allowing drawdown! Why is there a difference between allowing the capital sum be passed on from within the annuity, or from a pension pot which is in drawdown? In fact, many people probably go into drawdown just to be able to pass on funds on early death. If you address the death benefits issue, you will be able to prevent some people who would be better of with an annuity, from going into drawdown.
2. Allowing lifetime capital protection might appear to be moving too far away from the concept of drawing a pension
The Revenue seems afraid money back guarantees would appear to undermine the purpose of the tax breaks. Again, since they have already allowed drawdown, which allows the pension pot to be passed on if the person dies before age 75, it would surely be more logical to allow capital protection from within an annuity.
3. Allowing capital protection would possibly lead people to misunderstand the idea of insurance pooling which an annuity entails.
To be honest, I find this argument surprising. All the studies show that people do not have a clue about annuities. They don’t even know what they are, let alone understanding how they work! The FSA research project has confirmed that people really have no understanding of annuities at all. In fact, half the people in their survey, who had retired, did not even know they had bought one! If they don’t understand how annuities work now, by changing the rules they are unlikely to be confused in the future.
4. Capital protection would result in people getting less income!
This argument really is hard to justify. First of all, people will not be forced to take capital protection, it will be offered as an option if they want it. Secondly, the current situation is that MOST annuitants are living on less income than they should, because they have not taken the open market option. If you follow this argument through to its conclusion, it implies no one should go into drawdown, or take an escalating annuity, or the other options, since they might mean lower income.
The bottom line is that allowing capital protection is likely to improve perceptions about annuities and help encourage more people to put money into pensions. It will improve the freedom of choice. Everyone I have spoken to agrees that the death benefits issue is a major concern and puts people off annuities. We need to do everything we can to encourage more money into pensions. Either we are serious about this, or we are not!