Third Way Pensions
Overview
(Third Way Pensions are sometimes referred to as Guaranteed
Retirement Options.)
Against a background of increased volatility in stock
markets, perceived poor rates being offered for Lifetime
Annuities, concerns regarding future inflation and the fact
that people are now living longer, the retirement market was
in need of a new type of product. These new plans are
commonly known as ‘Third Way’ products and they are already
very popular in the US and Japan. Essentially they fit in
between a Lifetime Annuity and an Unsecured Pension plan as
they offer the chance to still participate in stock market
growth but with guarantees attached to either income,
capital or both.
Whilst each specific product does differ in its features,
the ‘Third Way’ pension is usually structured in one of two
ways:-
Annuity – this option is commonly structured as a fixed
term, value protected annuity plan, typically running for 5
years at a time, with the option to include guarantees to
protect maturity values or the level of income. Unlike a
traditional lifetime annuity, these products tend to offer
the ability to alter income levels between certain limits
and importantly, also allow the facility to provide a lump
sum on death.
Unsecured Income – the second type of Third Way plan is
structured as an Unsecured Income plan but with the option
to apply a guarantee to the initial investment so that your
fund value will never fall below what you originally paid
into the plan. Some plans also allow all or a portion of any
growth in the plan’s value to be locked in and a new minimum
guaranteed level is then set. Finally, the option to select
a guaranteed level of income is also commonly available.
Under both of the above options, you can choose to
immediately take a tax-free cash lump sum and then, instead
of buying an annuity, leave the remainder of the fund
invested in a tax-efficient environment.
If the income is not guaranteed it may vary between set
limits, and will be reviewed at some point between 1 year
and 5 years depending on the product chosen. The range of
income typically can be anything between nil and 120% of the
income that could be paid by a single life annuity and will
be based in the main on your fund size, age, sex, assumed
investment returns and your expected longevity. The maximum
limit is broadly equal to 120% of a single life annuity that
you could have purchased at that point. Where a guaranteed
level of income is chosen this tends to be a fixed amount
although increases may be possible.
These products tend to run until just before the plan
holders 75th birthday at which point a choice needs to be
made of whether to buy a standard Lifetime Annuity or move
into an Alternatively Secured Pension.
Please note that this type of contract can also be set up as
a Phased Unsecured Income or Phased Retirement plan as
mentioned previously,
Tax Free Cash
Most types of pension plan have the option of taking a
tax-free cash lump sum before exchanging the residual fund
for a series of payments. Ordinarily up to 25% of the fund
may be taken as tax-free cash, however if the pension funds
are or were part of an Occupational Pension Scheme or the
individual had applied for transitional protection, then the
available tax free cash may be greater than 25%. Tax Free
Cash must be taken at outset and once drawn, there will be
no further entitlement. Also, there will be no entitlement
to tax free cash from age 75 onwards.
Income
A pension income does not have to be taken but if this is
required, it cannot exceed 120% of the single life annuity
that you could have purchased at that point. This income is
taxed as earned income under the PAYE system.
Death Benefits
If you die whilst in a Third Way product the death benefits
can differ depending on how the particular plan you are
using has been set up. You therefore need to check the
specific product terms and Key Features Document. In general
however, they tend to fall into two scenarios :-
Under the annuity option - a return of the original purchase
price less withdrawals and less a tax charge of 35%.
Under the Unsecured Income option – a return of the fund
value at that point less a 35% tax charge.
Alternatively, beneficiaries may also have the following
options available to them:-
a) he or she can buy a lifetime annuity with the fund, or
b) he or she can choose to continue taking unsecured income
until they are 75, or
c) If the dependent is aged over 75 then they could opt to
move into an Alternatively Secured Pension
Advantages
● You are able to take all of
your tax-free cash lump sum entitlement at outset.
● Unless a guaranteed income is
selected, you do not have to receive a set income but are
able to vary it to suit your personal circumstances, up to a
maximum limit, to supplement other sources of income.
● You are able to mitigate your
liability to personal income tax in certain years.
● You have the potential to
benefit from good investment performance in a tax-efficient
environment and to exercise control over your own investment
portfolio.
● You are able to add a
safeguard in the form of a guarantee to limit any drop in
your fund value and some products allow gains to be locked
in.
Disadvantages
● High income withdrawals may
not be sustainable during the deferral period
● Taking withdrawals may erode
the capital value of the fund, especially if investment
returns are poor and a high level of income is being taken.
This could result in a lower income when the annuity is
eventually purchased and could also affect the long term
financial security of your spouse/partner.
● The investment returns may be
less than those shown in the illustrations.
● Annuity rates may be at a
worse level when annuity purchase takes place. Although
annuity rates generally increase with age, they have fallen
dramatically during the past 15 years. This trend may
continue.
● A careful investment portfolio
needs to be constructed which will involve some investment
risk. If capital guarantees are not included then this means
the fund value could fall which could affect your future
income levels.
● Withdrawing too much income in
early years may have an adverse effect on preserving your
pension purchasing power or preserving the capital value of
your fund.
● Increased flexibility and the
addition of guarantees bring increased costs and the need to
review arrangements on an on-going basis.
● There is no guarantee that
your future income will be as high as that offered by an
annuity purchased today.
● You may feel the prospect of
the future higher income does not compensate for the known
income available from an annuity now and for the rest of
your life.
● You may be prevented from
withdrawing your chosen level of income due to the action of
the GAD limits.
● The Financial Services
Authority (FSA) has particular concerns in relation to
mortality risk. If you purchase an annuity, you may benefit
from a cross subsidy from those annuitants that die
relatively early. This cross subsidy is not present with
Unsecured Income plans and so to provide a comparable
income, a higher investment return will be required. The
impact of mortality can be expressed as an annual percentage
rate by which the net investment performance of the
remaining personal pension fund would have to exceed the
interest rate implicit in an annuity in order to break even.
This effect has become known as the ‘mortality drag’.
● If you opt for an annuity
version of the Third Way plan the charges are typically
built in to the annuity rates offered. If you decide to
choose an Unsecured Income version of a Third Way plan, the
charges are added on top. Both of these are generally more
expensive than a traditional annuity or Unsecured Income
plan.
Inheritance Tax Issues
If it is unclear that there were not sound retirement
planning reasons for undertaking unsecured income and death
occurs, the use of this version of a 3rd Way contract may be
deemed as an attempt to circumvent the payment of
inheritance tax (IHT). Furthermore, if you are in ill health
and decrease the level of withdrawals with the intention of
keeping the funds in your plan, thus outside of your estate,
this may also be seen as a deliberate attempt to avoid IHT.
In both cases, the Capital Taxes Office, could issue a claim
and it is therefore vital that should your circumstances or
personal health alter, that you seek professional advice on
this very complex issue before reducing your withdrawals.
The Capital Taxes Office (CTO) recently clarified the
application of Inheritance Tax to this type of pension plan
and the results of their review were essentially that IHT is
unlikely to apply on death, except in the above scenario.
Critical Yield
For Unsecured Income versions of the plan you may be
provided with a Critical Yields figure. There are two types
(A and B).
Type A – the growth rate needed on the investment sufficient
to provide and maintain an income equal to that obtainable
under an equivalent immediate annuity.
Type B – the growth rates necessary to provide and maintain
a selected level of income.
Suitability
Both versions of this Third Way plan would generally suit a
relatively sophisticated investor, who is capable of fully
understanding the mechanics of the plan and the risks involved. The
contract can be used as a useful tax planning tool and a means of
accessing pension fund tax free cash without having to take the full
taxable income and it importantly allows the individual to defer
annuity purchase until their future plans are clearer. The
availability of guarantees allows this type of contract to be suited
to more cautious individuals who would not normally suit an
Unsecured Income plan however, the guarantees do come at a cost.