HILDA & JOHN ENHANCED ANNUITIES 20 July 2015 OBJECTIVES 1. John would like to secure a known income stream so Hilda can live a bit better should he die in the next few years 2. Ensure you don t have to worry about paying your bills if John survives, and perhaps have a holiday by the sea 3. Increase expenditure to 16,000 with immediate effect Main Issues 1. As well as his personal pension, John has a defined benefit [DB] scheme : 3,000 payable from 65, current transfer value 60,000 2. Your children are financially independent, although Dara can be a troublemaker within the family at times 3. You wish to use all your assets for your own needs 4. John s life expectancy may be only a few years 5. Your expenditure is 11,000 pa 6. You have been making up your income shortfall from savings 7. John is terrified his pension may reduce to zero in future with no income available to either of you Other Issues 1. Is pension transfer value same as fund value? 2. Any spouse s pension with DB scheme? 3. Any wills? 4. Lasting Power of Attorney ASSUMPTIONS Inflation : 3.0% Above the Bank of England predicted rate and the recent average for both CPI and RPI, but more realistic : several items of normal expenditure increase by more than the official rate. Savings Interest : 2.5% Generally behind inflation over the long term. Investment Growth : [before charges] Gilts 3.5% : risk-free return based on redemption yields Index-Linked Gilts 4% : 0.5% over inflation Corporate Bonds 4.5% : Typically 1% over gilts, allowing for extra credit risk Equities 7.5% : Based on historic equity risk premium of 4%, the difference between the return expected on equities and the risk-free rate on gilts. 1
Property Funds 5.0% : IPD All Property Index suggests longer-term growth 2.1% above inflation Life Expectancy [Hilda]: 100 Higher than the life expectancy of 90 years for a 68 year-old female [ONS Life Expectancy Calculator] but more cautious in calculating how long capital is needed. Annuity rates As sample quotations Other : 1. No ethical, social or environmental restrictions on your investments 2. Taxation rates remain unchanged, with allowances and exemptions increasing with inflation. 3. Expenditure reduces by 30% on first death INVESTMENT RISK You consider yourselves very cautious investors, only wanting to protect your money from the effects of inflation and nothing more. This, and your current holdings, suggests you may not be willing to see your investments fall in value. There are 3 aspects of risk tolerance : Risk capacity : the extent to which you could sustain a market decline without affecting your lifestyle / plan Risk required : the investment risk you need to take in order to have a reasonable chance of achieving your objective Risk attitude : your willingness to take risk in return for potential rewards Types of Investment Risk 1. Absolute risk : your investment may be less in value when you sell it than when you bought it. 2. Market risk : the risk within a geographical sector or market sector. International investments also carry the risk of currency fluctuations. 3. Specific risk : an individual part of your investment may fall in value. 4. Comparative risk : an asset may rise or fall in value compared to other assets, or to inflation. 5. Inflation risk : The possibility that the purchasing power of assets will be eroded. FINANCIAL POSITION Net Worth 31/06/2015 Excluding John s pension funds : 250,000, of which 44% is in liquid assets. Income Hilda s income is 8721pa, increasing with inflation leaving 1879 unused personal tax allowance 2
Cashflow 1. With your required expenditure of 16,000 the current shortfall is 7279 pa 2. Hilda s state pension is estimated as 86.96 per week; John should receive the new flat rate at 65, 151.25pw 3. John s total income then in today s terms would be 10,865, of which only 265 is taxable 4. Your total income would be 19,586 giving a surplus of 3586, again in today s terms 5. You could transfer up to 1060 of Hilda s unused allowance to John, which would make him a non-taxpayer. If John died Assuming no spouse s pension from the DB scheme : Hilda s income : 8721 Expenditure at 70% : 11,200 Shortfall : 2479pa Capital sum required 78,421 assuming all left on deposit EFFECT OF PENSION CHANGES 6 APRIL 2015 Income 1. You can now draw unlimited amounts from your pension plan. 2. This could be through regular payments [annuity or drawdown]; single amounts; or even the whole fund as a cash lump sum. 3. The first 25% of the fund is tax-free : all other payments are taxable as income 4. You therefore have complete control over how and when you use the money Death Benefits 1. You can nominate any beneficiary of your choice to receive drawdown funds on death 2. Beneficiaries can take the whole fund tax-free; or draw an income, via annuity purchase or drawdown. 3. On death before 75, the lump sum and income are tax-free. 4. After 75, the lump sum is currently taxed at 45% : after 6 April 2016, it will be taxed at the beneficiaries highest marginal rate. 5. Any income drawn will be added to their other income and taxed at their highest rate. 6. Unused drawdown funds can pass down through several generations. 3
OPTIONS FOR INCOME Annuity You could take 25% of your fund as tax-free cash, and use the rest to buy an open market annuity. Advantages 1. The annuity provides a guaranteed income for life. 2. You should qualify for an enhanced annuity : Certain annuity providers offer higher income than standard rates if you have medical conditions that are expected to reduce your life expectancy. You would need to complete a medical questionnaire, which explores your health and circumstances in detail. The provider s underwriters will usually require supporting evidence from your GP to determine the actual rate 3. This would give you 45,000 tax-free, and an annual income of c 7199 assuming level payments, continuing 100% to Hilda on death [level payments used as you have inflation-linking already on state and defined benefit pensions] 4. A 3%pa inflation-linked annuity would begin at 4848pa, and would take almost 12 years to reach the level payment of 7199 5. Under new rules, Hilda s income would be tax-free if you died before 75. Disadvantages 1. Buying an annuity is an irreversible decision : you must select certain options at outset which cannot be changed later 2. You do not need the whole tax-free cash : if you withdraw it, there are limited opportunities for tax-free returns outside the pension, whereas returns within the pension are tax-free. 3. At 65 the annuity would give you more income than you need 4. You can t change the named dependent : if Hilda died fist, there would be no dependent s pension 5. There would be no residual fund to leave your children, although this is not a priority Drawdown You could leave the funds invested and draw your income as required by encashing or crystallising part of your fund. There are 2 options : Uncrystallised Pension Fund Lump Sums [UPFLS] 1. You crystallise part of your fund as required, as a single lump sum or a series of withdrawals 2. The first 25% is tax-free : the rest is taxed as income at your highest marginal rate 3. Applying this to your income shortfall : 7279 required / 1819 tax-free / 5460 taxable. This is within your personal allowance, so no tax to pay. 4
Flexi-Access Drawdown 1. You can take 25% of the fund tax-free : in fact you could withdraw your required income from this part until it all used 2. You can withdraw whatever you wish at any time from the remaining fund, either lump sums or a regular income; all payments are taxed at your highest rate 3. Alternatively you can take no income, and leave the fund invested to continue growing Drawdown Advantages 1. You can take a regular income, occasional lump sums, or a combination 2. You have the option to take some or all of your tax-free cash entitlement 3. You have the flexibility to vary your taxable income, or taxable ad-hoc withdrawals, according to your requirements this can help reduce income tax. 4. You can choose how your money is invested, to suit your risk profile and income needs. 5. Your fund has the potential for further tax-free growth, which may improve the value of your future income. 6. It provides security for Hilda on your death : she could buy an annuity, continue drawing from the fund, or take the whole fund as a cash sum. All options would be tax-free on death before 75, taxable if it occurred after 75 7. Any fund left on second death can be passed to your children, free from Inheritance Tax Disadvantages 1. As your fund remains invested, its value can go down as well as up 2. There is no guarantee that your income will be as high as that from an annuity. Poor investment returns, particularly if combined with high income payments, could significantly reduce fund value and therefore future income. 3. Your pension fund may not achieve the required level of growth to maintain income if you live longer than expected. 4. There is no guarantee that annuity rates will improve in future : if you decided to buy an annuity later, your pension may be lower than if you had bought at outset. 5. You would be charged more for an income drawdown plan than for an annuity, owing to the need for ongoing review. 6. There may be administration charges each time you arrange an income payment Final Salary Scheme We could carry out a transfer analysis to show whether it is feasible to transfer to a personal pension, which would give more flexibility over how you draw the benefits. This may be worth considering if the scheme does not offer a spouse s pension for Hilda. 5
As an initial guide : 1. It may be possible to commute part of your pension to tax-free cash, with a reduced income 2. To achieve the same income using the full transfer figure, ignoring commutation, and assuming 3%pa inflation increases you would need a return of over 6.03%pa. This would involve more investment risk than your profile suggests. 3. Using the same enhanced annuity rate as above [5.07%], the transfer sum would give you 3042pa level payments, 50% spouse pension to Hilda 4. While the difference may be small, you would have 3 years extra income - 9126 5. After 10 years, you would have received 30,420; if the DB scheme starts at 65, it would have to pay out for 12 years before the amount received exceeded the amount received from an enhanced annuity 6. You could take 25% tax-free - 15,000 with a reduced annuity of 2281pa. EXISTNG INVESTMENTS 1. The savings account is an ideal contingency fund, but should be in joint names so Hilda can access it more easily should John die 2. Cash ISAs have tax-free interest, but it does not normally keep pace with inflation so the spending power reduces over time 3. ISAs now retain their tax-free status when passed to each other on death 4. The asset allocation of John s pension does not match your risk profile. The equity exposure is too high Returns have been well above inflation over 20 years, but a similar portfolio would have fallen 17% at one stage during the past 10 years. We would normally include [commercial] property and possibly other assets for further diversification 6
RECOMMENDATIONS Pensions 1. Take 25% tax-free cash from your pension fund 2. Subject to confirmation from underwriters, use the remaining fund to buy an enhanced annuity with the following options : Level monthly payments, no annual increase 100% Spouse pension No guarantee period required 3. Confirm whether or not the defined benefit scheme provides a spouse pension, and how much may be commuted to tax-free cash 4. We can then compare with an enhanced annuity beginning immediately Savings & Investments 1. Retain cash ISAs, and review interest currently received 2. Invest 15,240 each from tax-free cash into stocks and shares ISA, using an indexlinked gilt tracker fund 3. Put remaining 14,000 in 1-year deposit account, to be invested in ISAs at maturity Income Provided Annuity : 7069pa [assumed paid monthly, 589 pm New ISAs : c640 after charges DB Transfer [if feasible] : 2295 pa MEETING OBJECTIVES Income 1. The annuity provides the secure and known income stream which you required from your pension. 2. It will pay for the rest of John s life 3. The income is calculated on your current state of health and will not be affected if the prognosis proves wrong and your health improves. 4. You do not need to worry about your pension fund reducing to zero and leaving you and Hilda without income. 5. Your income is not affected by stockmarket falls or interest rate fluctuations 6. The quoted annuity would almost cover your shortfall of 7279, enabling you to increase your spending by 5,000 7. Any remaining shortfall can be made up by income from your ISAs [tax-free], or withdrawal from the savings account 7
8. Your remaining capital remains intact, for holidays or other unforeseen needs such as extra medical care Benefits for Hilda 1. The annuity continues in full should John die first, providing her with a known income without having to decide about annuity guarantee periods. 2. Although it would provide more than our estimated shortfall, the extra amount would help her to live a bit better 3. The continuing annuity income would be tax-free if John dies before age 75, so Hilda would remain a non-taxpayer. 4. She would also inherit John s ISAs, which would continue to provide tax-free income and growth Cashflow 1. By taking level income, you maximise the amount payable immediately. 2. At age 65 you would have 4 other sources of income increasing with inflation : two state pensions, Hilda s annuity, and [assumed] the DB scheme. 3. As you would already have enough income from these sources to meet your required spending, you can save the surplus to protect against the future effects of inflation. 4. The revised cashflow shows your money would never run out : you could increase your spending by a further 4200pa, increasing with inflation. 5. The stocks and shares ISAs may fluctuate in value, but with regular income secured this would not affect cash-flow. Charges 1. Annuity : Adviser charge 1% of purchase price, already allowed for in quoted income 2. Stocks and shares ISAs : no initial charge; on-going charges 0.25% [already allowed for in the income figure above]. OTHER MATTERS 1. Review, or make, wills 2. Lasting Power Of Attorney, in case you became mentally incapacitated - or John s health deteriorates - and cannot make reasoned decisions about health and finances. 8
IMPLEMENTATION Within 1 month Clients / Planner Confirm attitude to risk Agree income strategy Medical Questionnaire Annuity application With Solicitor Lasting Power of Attorney Wills Within 2 months Planner Check DB scheme Clients / Planner New ISAs Review existing ISAs REVIEWS Regular review not needed only as requested by clients 9