Expats should double-check their pension arrangements after leading UK insurer Royal London offered 33,000 savers “large cash boosts” as an incentive to surrender high interest rates on annuity payments locked into valuable old pension policies (The Telegraph).
Some savers are sitting on pensions so valuable that they are costing insurers too much money; speak to your IFA to find out if that means you! If so, the term “Guaranteed Annuity Rate” may ring a bell?
What is a Guaranteed Annuity Rate?
What Royal London want policy-holders to give up specifically are the terms of their pension called “Guaranteed Annuity Rates”.
A Guaranteed Annuity Rate is a fixed rate of interest that applies to annuities. This rate determines how expensive it is for insurers to honour key financial obligations to pension-holders.
What is an Annuity?
An annuity is a financial arrangement relating to Defined Contribution (DC) and Defined Benefit (DB) pensions (but not the UK State Pension). For you the pension-holder, purchasing an annuity means exchanging a lump sum from your own pension pot for a fixed annual payment from your insurer – hence the term “Annuity”, because the payment made to you is made annually.
Old UK rules stipulated that pension-holders were legally obliged to purchase an annuity with at least some of their pension pot, but the Pension Freedoms of 2015 removed this obligation. UK pension-holders are now free to buy an annuity as they see fit. Annuity rates in June 2016 hit an all-time low after almost a decade of falling but have since consistently gained in value.
Why are Guaranteed Annuity Rates making some pension-holders rich?
Guaranteed Annuity Rates came as standard in millions of pensions during the 1980s and 1990s. They allowed pension-holders to lock in the high interest rates of the times (10%+) to apply to the annual payments made to them by their insurer in the future (ie. now). So nowadays annuity-holders with Guaranteed Annuity Rates rake in roughly twice what annuity-holders with modern interest rates do.
The Telegraph is accurate in its judgement that, “at today’s best annuity rates a £100,000 pension could buy a 65-year-old around £5,400 of income a year for life” whereas a holder of an older annuity with a Guaranteed Annuity Rate would be looking at more like £10,000 a year in income.
So, for insurers, Guaranteed Annuity Rates are a costly hangover from the past. When these rates are involved, insurers are effectively obliged to make annual payments going forward into the 2020s with high interest rates from the 1980s. But that’s not the only problem for insurers. Life expectancy has rocketed since the 1980s too – meaning insurers are obliged, on lifetime annuities, to make more annual payments per pension-holder than in the past. (Some annuities – called temporary annuities – are of a fixed term and not paid out till death).
So what should I do if I am offered cash to give up my Guaranteed Annuity Rate?
Well the first thing to do is get some advice – obviously. Do your research online, but ask somebody who knows! In the UK, if a pension is worth £30k+, the pension-holder is legally obliged to take advice from a financial professional in the event that guaranteed income is to be surrendered. In this case under the spotlight, Royal London have offered to cover the cost of that financial advice. Remember that, in making a cash offer in the first place, the insurer has shown that it views your Guaranteed Annuity Rate to be a prize target.
This issue of surrendering a fixed income for the future centres on a saver’s attitude to risk. It is inherently risky to surrender future fixed income. But clients with small pension pots in particular may see Royal London’s offer of cash as a chance to get hold of a lump sum rather than endure a pittance of an annuity over coming years. Others with larger pension pots might find that the guaranteed income is a far better bet – particularly if other liquid funds are available to service Life objectives, like funding the grandchildren’s education.
Changing your pension arrangements MUST always be considered in the context of your entire financial picture, with all its complexities and possibilities. A qualified IFA is ideally suited to look into this issue.