1 For financial intermediaries only. Not approved for use with customers. Bulletin Update following the chancellor s announcement on 25 November 2015 The Finance Act (no 2) 2015 received Royal Assent on 18 November This confirmed that from 6 April 2016 the tax treatment applicable on the payment of lump sum death benefits will be at the recipient s marginal rate of income tax, in the following situations: For those individuals who die on or after age 75, or For those individuals who die before age 75, and where applicable, the payment is made outside of the relevant two year window. This tax treatment is conditional on the recipient meeting the qualifying person definition, which is any individual not classified as a non-qualifying person. A non-qualifying person will continue to be taxed at 45%, and is either: an entity other than an individual, or an individual acting in the capacity of a trustee (other than a bare trustee), personal representative, director of a company, partner in a firm or member of a limited liability partnership. Extended Guarantee Periods vs Value Protection An overview of where a guarantee period or value protection might be most appropriate Part of the changes introduced by the pension reforms in April 2015 has been the overhaul of death benefits, in particular the lifting of certain restrictions, as well as changes to how benefits are taxed. This has culminated in some annuity providers making changes to their products to incorporate extended guarantee periods, as well as re-invigorating value protection. This has also, however, added a layer of complexity for advisers and retirees when considering which approach now caters best for their needs in terms of cost against value and suitability for the annuitant and their beneficiaries. Pension legislation does not permit the inclusion of both a guarantee period and value protection under the same annuity contract. Therefore the decision as to which option should be selected, if any, needs careful consideration. They were originally designed to offer protection on different elements of an annuity purchase: a guarantee period aims to protect the income selected (this may or may not correspond with the original capital committed) value protection (first introduced in April 2006) aims to protect the original capital. However this distinction in respect of guarantee periods is now somewhat blurred as a result of the greater flexibility available from 6 April For example, it s now possible for the annuity provider to offer the beneficiary the option to commute their guarantee period in some scenarios.
2 Extended Guarantee Periods vs Value Protection Extended guarantee periods for pension annuities: Prior to the pension reforms, pension annuities could only provide a guarantee period up to a maximum of 10 years. From April 2015 the restriction was lifted, and several pension annuity providers are now offering guarantee periods of up to 30 years. If the death of the annuitant occurs on or after the 3 December 2014 and prior to age 75 the income is paid tax free to the beneficiary. If death occurs after age 75, the income guarantee is taxed at the beneficiary s marginal rate of income tax. In addition, any remaining guaranteed period can now be paid out as a trivial commutation lump sum death benefit (TCLSDB) if the contract allows for this and the following requirements are met: the amount valued and made available must be less than 30,000 and it extinguishes the individual s entitlement under the annuity It should also be noted that there is still no provision to attach a guarantee or term certain to a dependant s pension annuity (or indeed a nominee s or successor s annuity). Furthermore short term annuities (which are payable out of drawdown funds) can still only have a maximum guarantee of 5 years. Value protection: This option is often discounted for a number of reasons. One such reason was the previous tax treatment of the death benefit. Due to the size (55%) of the special lump sum death benefit tax charge it meant there was question around the value of this feature. With changes to the tax treatment this option has now become viable once again. In the event of death, a lump sum is returned, less all the gross income payments that have been made since the pension annuity went into payment. If death occurred before age 75, the annuity protection lump sum would be paid tax free. If death is after age 75, then for the 2015/16 tax year the payment would be taxed at 45%. The Summer Budget proposed that this tax treatment will continue forward into April 2016/17 for a non-qualifying beneficiary (such as a company). However for a qualifying beneficiary this will be assessed under PAYE and will be taxable at their marginal rate of income tax from 2016/17 onwards. This is likely to lead to a tax reduction for most recipients, however, this is still subject to final legislation. Depending on the features available within a particular annuity contract, it is possible that value protection can be set up on the death of the first life or on the death of the last survivor, if dealing with an annuity with a built in spouse s/ dependant s pension. 2
3 Considerations: The main difference between guarantee periods and value protection is how the benefits are provided to the beneficiaries, either as a continuation of income in the case of guarantee periods (unless they are commuted), or as a lump sum if provided through value protection. Essentially, both of these options can now provide a greater degree of insurance in the event of death. The aim is not only to provide some form of benefit to beneficiaries, but also afford the annuitant the knowledge that their annuity capital is not completely lost to the provider. Tax When establishing the most appropriate death benefit option, a key consideration is the tax position of the intended recipient(s). The different tax liability arising as a result of an additional income stream when compared to a one off lump sum could be significant. This is especially true from April 2016/17 onwards, for deaths over the age of 75 meaning certain recipients will be taxed at their marginal rate. For example the impact of 4,000 per annum received for a further 10 years versus a single payment of 40,000 in a particular tax year. The beneficiary s circumstances Another key consideration is the appropriateness for the intended beneficiary/ies of a potentially sizable capital sum. For minors (for example, grandchildren) it should be possible to pay either the lump sum or any income stream to a parent or legal guardian. However those over the age of majority will be free to spend any death benefits as they wish. The financial position of the beneficiary and the impact on their estate may need to be evaluated. Factors such as; loss of any means tested benefits, potential bankruptcy, possible divorce and the inheritance tax position may be relevant. It may be possible to utilise a trust as a vehicle to receive the value protection lump sum and this can help manage the death benefits more closely in line with the annuitant s wishes. However the contrasting tax position between paying to a trust and paying directly to the beneficiary should also be considered. Subsequent death before the end of the guarantee period In the case of guarantee periods, should the recipient die whilst any remaining guarantee is outstanding, this can be passed on. However where these payments are being paid at the discretion of the annuity provider, they retain the discretion to appoint to a new beneficiary. 3
4 Extended Guarantee Periods vs Value Protection Cost vs value: Deciding on which option to use is very much dependent on the individual needs of the retiree. One of the biggest factors may be the desire to receive back all of the capital used to initially purchase the annuity at outset, either as income for the retiree or in combination with the gross death benefits payable. Examples using guarantee periods Taking extended guarantee periods first, we can use some examples 1 to compare the cost against the potential value returned: Annuity initial capital purchase 50,000 Guarantee Period selected Annuity income p.a. 2,916 2,840 2,526 2,151 Total income - with guarantee N/A 28,400 50,520 64,530 Total income - without guarantee N/A 29,160 58,320 87,480 Cost of guarantee in reduced income ,800 22,950 % of initial annuity capital covered at the end of the guarantee period 0% 57% 101% 129% This shows us that in the case of a guarantee period lasting for: 10 years for a cost of 760, the annuitant has been able to insure that they, or their beneficiaries, would receive back at least 57% of their original 50,000 capital if they died within the first decade of their annuity payments. 20 years this is the breakeven point which shows that the annuitant (or their estate) would have received back 101% of the original annuity capital. The cost for this is the equivalent to giving up 2 years and 8 months worth of nonguaranteed income (i.e. 7,800 / 2,916 = years). 30 years the annuitant (or their estate) has now moved into positive cash flow, with a return of cumulative income against initial annuity capital outlay of 129%. This is further demonstrated in the graph below: Extended Guarantee Periods 70,000 60,000 64,530 50,000 Total income 40,000 30,000 20,000 10, , , , ,950 Total income with Guarantee Cost of guarantee in reduced income Annuity capital 4
5 Examples using value protection Value protection provides capital protection in a different way. The simplest way is to imagine the annuity capital as a pot of money, which is returned to the annuitant either as income whilst the annuitant is alive, or in the event of their death, will be returned as a lump sum (to their estate/beneficiary) consisting of whatever is left in the pot and that hasn t been taken as income. There are, of course, tax considerations to bear in mind as mentioned earlier, but in summary it will offer the ability to insure the original capital. If we continue with our example of an individual aged 65 with a 50,000 pension fund. Assuming they select a single life annuity with no additional features their starting income would be 2,916 per annum. If they chose to purchase 100% value protection as a death benefit, this would reduce the annuity to p.a. The cost of the value protection can be calculated as p.a. as a result of the reduced annuity income. For illustrative purposes, all of the figures shown in the following examples are gross, and do not take into account any potential tax. The example below shows how long it would take for the capital to be used up, and therefore what the breakeven point for value protection would be: Value Protection 50,000 4,000 45,000 3,500 Value Protected capital remaining 40,000 35,000 30,000 25,000 20,000 15,000 10,000 3,000 2,500 2,000 1,500 1,000 Ongoing annuity Income 5, Income Cost pa Value protected capital remaining based over 20 years 0 The capital protection in this example would stop after 20 years. If the annuitant lives for this long, then they would have received all of their initial investment back in the form of income by this time. In this example the breakeven point for value protection is broadly the same as that for a 20 year guarantee period. However the breakeven point for an individual retiree will vary depending on the prevailing annuity rate, fund value and the level of value protection selected. 5
6 Extended Guarantee Periods vs Value Protection Comparison of protection offered The obvious difference with value protection as compared to a guarantee period is that a term does not have to be chosen, rather the percentage of capital (0 100%) that the annuitant wishes to cover. Assuming 100% value protection is chosen then their chosen beneficiary is guaranteed to always receive their money back (with the exception of any tax paid). In contrast, with a guarantee period there is an element of trade-off, as the annuitant will need to select a set term at outset which cannot be subsequently changed. The period selected may not equate with ensuring the capital value used to purchase the annuity is paid back in full. It would be possible to calculate the approximate period required although currently a part year guarantee is not offered, so it would unlikely be an exact match. In the above example of a 65 year old, if the annuitant chose a 10 year guarantee term, they will not receive all of their annuity capital back as income in the event of death, whereas a 20 year guarantee will do so. Value protection is designed to insure the capital; if this has been returned as income, then there is no further protection, whereas a 30 year guarantee period will continue for another 10 years worth of income beyond the 20 year breakeven point where the capital has been returned. Lastly, the costs for the provision of value protection, in terms of reduced income in the example above are per annum (value protection graph, page 5). This means that the total cost of insuring the return of capital has been approximately 9,200 (20 x ). By comparison with the example of choosing a 20 year guarantee period, the cost for value protection is higher by 1400 ( 9,200 vs 7,800 see extended guarantee periods table, page 4). Longevity When deciding on whether to choose any death benefit such as value protection or a guarantee period, a further aspect to explore is how long the annuitant is likely to live. A 65 year old male, as represented in the examples above; using UK Pension Industry Data (Continuous Mortality Investigation 2015), in good health, would have a 3 in 4 chance of living to 89, and 1 in 2 chance of living to 96. For females this is 91 and 98 respectively. Even with average 2 health, men have a 3 in 4 chance of living to 80 or 1 in 2 chance of reaching 87, (83 and 90 respectively for women). 6
7 Summary and next steps: The removal of restrictions on guarantee periods and changes to taxation on death benefits, considered alongside increasing longevity expectations, mean that the days of having a 5 or 10 year guarantee as standard for people retiring in their 60s are numbered. The use of value protection, or an extended guarantee period means that lifetime annuities are now able to provide money back options, which goes a long way to removing one of the most common objections to annuities, that of if you die, then the money dies with you. As to which option is better, although we have explored some differences in cost and value, the decision is very individual to each client s circumstances. This will likely depend on planning considerations and some of the softer facts around the annuitant s wishes for their legacy planning. The type of question that might be posed could be: What are you most interested in protecting? If the preference is for income then this may suggest a guarantee period. Conversely if a capital sum is more desirable then this might suggest value protection. Further questions could include Who should benefit, do you have any concerns on how they could handle these monies and what is their tax position? This will help ensure any expression of wishes is completed correctly and what the implications of any income payment or capital payment may have on the beneficiaries financial position. Finally, should the development of the secondary annuity market progress, any contingent benefits such as a guarantee period or value protection should add additional value to the contract for any subsequent re-sale. 1 Based on a 65 year old individual, 50,000 annuity purchase, single life basis, enhanced, non-escalating. 2 Average Health assumes that you are neither in perfect health for your age but nor are you suffering from any serious ongoing illness. You might, for example be a little overweight and/or your blood pressure may be a higher than your doctor would like it to be, or perhaps you might be suffering from high cholesterol and taking controlling medication. 7
8 For more information contact: Telephone: Lines are open Monday to Friday, 8.30am to 5.30pm. us: Or log onto our website for further information: Just Retirement Limited. Registered Office: Vale House, Roebuck Close, Bancroft Road, Reigate, Surrey RH2 7RU. Tel: Registered in England Number Calls may be monitored and recorded, and call charges may apply. Please contact us if you would like this document in an alternative format /2015