This piece first appeared in Saga Magazine in September 2001
The text here may not be identical to the published text

Set Our Pensions Free


The case against annuities

Conservatives, Liberal Democrats, and ex-Labour MPs are uniting to demand that the Government scraps the rules which force thousands of people to put their pension funds into poor value investments when they retire. These investments are called annuities. They give barely half the returns they gave fifteen years ago. But the Government still forces everyone with a personal pension, and many people with pensions paid through their company, to buy one. I explained this pension trap last month. And now Saga readers can join in a campaign for change.

Dr Oonagh McDonald was Labour MP for Thurrock in Essex for 11 years until 1987 and now, in her 60s, is a company director and a consultant on pensions and the financial services industry. A year ago she found herself in sight of her own Rubicon.

"I realised I was approaching the age when I would have to buy an annuity and I didn’t want to. So I set up an independent, unpaid group to look at the alternatives."

The Retirement Income Working Party drew on her extensive contacts in the financial services world to bring together insurance company directors, pension fund managers, and academics – together with a group of equally high-powered advisers. In March last year they produced their report Choices which challenged the Government’s policy on pensions and annuities.

That policy, which is the same as previous governments have adopted, goes like this:

People are allowed to save money into a pension fund tax-free. That is a big subsidy from the State. So when that fund is converted into a pension, two things must happen. First, the pension must be taxed – otherwise people would be savings tax-free and also paying no tax on those savings when they were used. Second, the fund must be converted into a safe income for life. Otherwise, people could save up tax-free, retire, spend the money, and then fall back on the state again to keep them.

Annuities fit that bill precisely. All the fund is used to buy an annuity which gives a guaranteed income for life. There is no danger of the money running out and the income is taxed before it is paid, just like earnings.

Oonagh McDonald thinks such an approach is old-fashioned.

"The obligation to purchase an annuity is a very old one, it goes back over 100 years. It was first introduced, with exactly the arguments that are repeated now, in a Royal Commission Report on Civil Service Pensions in 1898. Then civil servants received a lump-sum on retirement and it was decided to impose the obligation to purchase an annuity because otherwise they might spend the money and fall back on charity or the state. And that is still the driving force behind the policy; it hasn’t changed at all."

But the world has. Pensions for middle class professionals took off in the 1950s, expanded in the Thatcher pension revolution of the 1980s and now, with stakeholder pensions, will spread to all parts of society within a generation. She believes that means the system has to become more flexible.

"Retirement provision has to be geared to people’s individual needs and be flexible as they change, bearing in mind that the length of retirement is increasing. Now a man of 60 can expect to live more than 20 years and a woman 25 years. That’s four or five years more than a generation ago."

Annuities by contrast are completely inflexible. In exchange for our pension savings an insurance company gives us a guaranteed income for life. It cannot respond to any change in our circumstances. And the income it provides represents a very low return on what can be a big pot of money. Why should someone who has saved up £100,000 be forced to convert it into a very low, fixed income when given the freedom to invest it themselves they could enjoy a higher income and have something to leave their children?

The Government sees it differently. Pensions Minister Ian McCartney told Saga Magazine

"The valuable tax privileges granted to pension schemes are given specifically to encourage people to put money aside for a pension. If there were to be no restrictions at all on the use of the funds built up in the scheme, the taxpayer would be providing a pensions tax subsidy to what would be, in effect, a general savings plan, and I do not think that this could be justified."

But Oonagh McDonald and her team of experts has an alternative, which answers the Government’s concerns. Their proposal is simple. If people could guarantee that their income would always be well above the amount where they would be a burden on the state, then the obligation to buy an annuity with the rest of their pension fund should end. The question is, what level of income is that? The Government guarantees that any single pensioner with an income below £92.15 a week will get it topped up to that level. So the amount would have to be higher than that. Her team aimed a lot higher – roughly double the state retirement pension.

"Individuals would be obliged to provide themselves with the minimum income which we set at £140 a week including the basic state pension, index-linked to protect against inflation."

Broadly speaking, people with a full state pension and no other regular income would have to buy an annuity to give them around £70 a week, index-linked to ensure it rose each year with inflation. At 65, such an annuity would cost around £60,000. Anything left in the pension pot above that could be used more freely. But the committee fell short of recommending complete freedom.

"The legal obligation should be minimised so if you wanted much more security you would still be free to buy an annuity with all your pension fund. But if you wish to invest part of your fund in shares or in property or whatever then you would be free to do that. With freedom goes responsibility and that does require proper financial advice. If you wanted to withdraw capital to spend, then you could do that, but the Inland Revenue gives you tax relief to save up for a pension and it would therefore want to tax it when you spent it."

All that of course implies a continuing state interest in what pensioners do. And it also raises the fear of the financial services industry hovering like bees round a pension pot, waiting to take commission for the investments people are then free to make. But at least the report forms a valuable basis for discussion.

Sadly, the Government does not think so. Alistair Darling, the Secretary of State at the Department for Work and Pensions, privately believes that her plans would help very few people. The average amount used to purchase an annuity is thought to be around £30,000. So the numbers with more than £60,000 would be relatively few. But Dr McDonald dismisses his argument.

"That is exactly what the Government doesn’t know and neither does anyone else. The industry gives an average figure of £25,000 to £30,000 per pension pot. But no-one knows if that individual has other savings, or whether they have pension policies with anybody else – or even another with the same company. The Government just does not have the data available to support that claim."

Even on the basis of the poor data that is available, her report estimates that at least a quarter of people with annuities would currently have ‘surplus’ funds once they had provided themselves with a guaranteed income of £140 a week. But in future Dr McDonald says that number will grow.

"My view is that it will help a lot more people even if they have only £10,000 left over. Personal pensions have been around for only 13 years, stakeholder pensions are just beginning. Pension pots will be larger in the future. What we’re saying is that successive governments have focused on people saving up for retirement, but having reached retirement, as more those people than ever will do over the next 20 or 30 years and they will also live longer, isn’t it time we thought about making the best use of the pension that has been so painfully saved up?

The Government stands by its current policy. At the Budget this year the official line was "many of the ideas submitted would have substantial costs, running into many hundreds of millions of pounds. The Government, however, appreciates that concern has been expressed and will continue discussions with interested parties on workable and affordable alternatives."

Other political parties are not so complacent. The Liberal Democrats and the Conservatives both had reform of pension annuities as part of their manifestos at the General Election. And the Government may soon be forced to debate the issue seriously with its critics. Conservative MP David Curry came high enough in a ballot of backbench MPs to put forward his own Bill and see it fully debated when Parliament returns in the autumn. He has chosen a Pension Annuities (Amendment) Bill which would remove the requirement to buy an annuity with the whole of the pension fund. It will be debated in the New Year on January 11.

So it may be time for Saga readers to write to their MP – particularly if they belong to the Labour Party. For all its talk of modernisation it alone sticks to an annuity principle which was first imposed in 1898. In 2002 perhaps it is time to set our pensions free.

September 2001


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