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The Actuary The magazine of the Institute & Faculty of Actuaries

Annuities and restriction risks

Until relatively recently, savers in money-purchase pension schemes were effectively required by government regulations to purchase an annuity with their pension fund by the time they reached age 75. Since April 2011 the government has lifted this effective requirement to annuitise. This article explores the possible impact of this policy change and estimates the number of people who might be able to take advantage of the government’s new flexibilities. 

From April 2011 individuals with a money-purchase pension will still be able to purchase an annuity at any point from age 55, however, they will not be required to purchase an annuity. The new regulations will also allow people to:
>> Invest some or all of their pension savings in an income drawdown arrangement with no age restriction, with a withdrawal cap of 100% of what they would have received from an equivalent annuity, ‘capped drawdown’.
>> Withdraw unlimited amounts from their pension savings, provided that they can demonstrate that they can meet the government’s minimum income requirement (MIR) by showing that they have a secure income, guaranteed for life of at least £20,000 per year (in 2011), ‘flexible drawdown’.

The new regulations will give people more flexibility to potentially grow their pension savings during retirement and to aim to preserve some of their fund to leave as inheritance. For people with large savings and a high appetite for risk, the changes will be very welcome and could be beneficial. However, individuals deciding to use the new methods may also be exposed to more risks to their retirement income. This is because the level of risk that an individual faces when accessing their pension savings is related to the method they use to unlock their savings. For example, income drawdown provides individuals with more scope to try to grow their pension fund, but it also exposes them to the risks of poor investment returns (investment risk) and to the risk of depleting their funds before death (longevity risk).

There is no regulatory restriction on the size of the pension pot a person needs to enter income drawdown, however, many independent financial advisors recommend people need a pension pot of a minimum of between £100,000 and £250,000 as well as other income and assets in order to ensure people can bear the investment risk and longevity risk associated with drawdown.

If it is assumed, for illustrative purposes, that people with pots of £100,000 or more might be in a position to purchase an income drawdown product, then, based on existing market data and analysis, Pensions Policy Institute (PPI) estimates suggest that around 600,000 to 700,000 people — around 5% of all those aged between 55 and 75 in 2010 — could potentially make use of capped drawdown because they are either already in income drawdown or have enough defined contribution (DC) pension savings to enter capped drawdown.

In addition, the PPI estimates that around 200,000 people — around 2% of people between age 55 and 75 in 2010 — could have sufficient pension income and DC pension savings to meet the MIR and be able to withdraw some savings through flexible drawdown. Taken together, these findings suggest that, even after this policy change, for the vast majority of people, annuitising is likely to remain the safest and most appropriate option for accessing private DC pension savings. In 2010 the vast majority of people aged between 55 and 75 would not have had a large enough private pension pot to be able to bear the investment and longevity risks associated with capped drawdown and would not have been able to meet the MIR.

More people might be able to use capped or flexible drawdown in future. Part of the reason why such low numbers of people between the ages of 55 and 75 in 2010 might be able to access capped or flexible drawdown is the historically low levels of DC saving. However, the decline in defined benefit pension provision has led to an increase in people saving in DC schemes, which is likely to increase when auto-enrolment into pension savings begins in 2012. It is probable that over the next few decades, the number of people reaching retirement with DC savings will increase and that, in the future, more people will have an opportunity to access capped or flexible drawdown.

However, the government will need to ensure that these individuals have access to appropriate advice and information to ensure that they understand both the potential upsides but also the inherent risks in such an approach. The PPI is an educational research charity with a charitable objective to inform the policy debate on pension and retirement income provision. This article is based on research conducted as part of the PPI’s retirement income and assets series. The full report can be downloaded from the PPI’s website www.pensionspolicyinstitute.org.uk


Niki Cleal is director of the Pensions Policy Institute