Ahead of tomorrow's Budget, Towers Watson comments on reports that the Lifetime Allowance for pension savings could be reduced to £1 million. The consultancy also discusses how a market in second-hand annuities might work, and wonders whether the Chancellor might unveil the starting value of the single-tier State Pension (perhaps around £155 a week).
A £1 million Lifetime Allowance
The Sun has reported that the Chancellor will cut the Lifetime Allowance for pension savings to £1 million in tomorrow's Budget. A 55% tax charge applies to excess pension savings above this value when people draw their benefits (compared to their marginal rate of income tax at the time, typically 40%).
The Lifetime Allowance has already been cut twice under the Coalition Government – it fell from £1.8 million to £1.5 million in April 2012 and then to £1.25 million in April 2014. Labour and the Liberal Democrats have called for a further reduction to £1 million; this is one of three restrictions on pensions tax relief that Labour say would pay for a cut in university tuition fees.
Jackie Holmes, a senior consultant at Towers Watson, said:
"At today's annuity prices, a £1 million defined contribution pension pot would buy an RPI-linked annuity of just under £27,000 payable from 65 (before taking any tax-free cash) if the saver wanted to secure an income for their spouse after they die. That number will move around with annuity rates. For people in defined benefit schemes – which for the future will mostly mean the public sector – the maximum pension within the Lifetime Allowance ceiling would fall from £62,500 to £50,000. Had the old tax rules from before 2006 continued to apply, the maximum permitted pension would now be £99,600.
"One problem with a lower Lifetime Allowance is that more people will have to guess whether investment returns will take them above it when weighing up the case for adding to their pension savings. For example, if someone's pension pot is already £614,000 and they plan to access their savings in a decade's time, investment growth of 5% a year would take their pot above £1 million even if they do no further saving. Some people with pots much smaller than £1 million could therefore stop saving in pensions on the back of this. It would help if the Government could indicate that the Lifetime Allowance will keep pace with prices or earnings, but the recent trend has been to reduce it further rather than maintain its value.
"Many employers – at least in the private sector – offer cash alternatives to pension contributions for high earners where the Lifetime Allowance makes pension saving less attractive. Where they don't, employees should think carefully before they stop saving in a pension to avoid a tax charge: even after paying 55% tax, you still get 45% of the value of the employer contribution, and 45% of something is always better than nothing.
"If the Lifetime Allowance is reduced, we expect that the Government will announce transitional protection for people whose pension pots are already above £1 million."
The second-hand annuity market
HM Treasury confirmed on Sunday that a consultation paper to be published alongside the Budget will discuss how to launch a market in second-hand annuities in 2016.
Issues on which more details might be provided include: the help for individuals thinking of selling annuities; the strength of the Government's commitment to excluding defined benefit pensions; whether some annuitants may be unable to cash in; why the Government is not minded to allow insurers to buy back their own annuities; and how the Government sees buyers, sellers and intermediaries coming together.
Mark Duke, a senior consultant at Towers Watson, said: "So far, the Government has only talked about making sure that people get 'appropriate guidance' before giving up a secure lifetime income. It has not said that annuity sellers must take financial advice in the same way as people have to before transferring out of a final salary pension scheme before retirement. If advice were required, there would probably be an exemption for people whose annuities aren't worth much. One difficulty with this is whether to exempt older pensioners whose annuities have a lower value because they are not expected to live for as long."
Is this the final extension of pension freedom? Or will defined benefit pensioners ever be included?
Mark Duke said: "There has been no suggestion that retirees with defined benefit pensions will have the same freedom as annuitants to cash them in. The consultation paper might signal how determined the Government is to draw the line here. So far, the trend has been towards extending pensions freedom to groups who originally felt excluded. Choices have been extended to defined benefit members who have not yet retired and now to existing annuitants – will defined benefit pensioners be next? They won't have choices extended to them in the Budget, but will this be the next step?"
Can all annuities be sold?
Mark Duke said: "We doubt that people will be able to sell annuities that were assigned to them when a final salary pension scheme got bought out with an insurance company – a situation that should become increasingly common. These policies may be annuities as far as the member and the insurer are concerned but the tax rules treat them as 'scheme pensions' instead.
"There are also question marks over annuities bought by trustees on behalf of individuals with defined contribution savings and held in the trust – this used to be common in occupational schemes. It might be that not everyone who thinks they can sell their annuity will be able to.
"However, it does not look as though people wanting to sell their annuities will have to satisfy any kind of income test to demonstrate that they won't fall back on means-tested benefits."
Who can buy? Who will sell?
The Government has said that its proposal "will not give the annuity holder the right to sell their annuity back to their original provider, and the government is not minded to allow the original annuity provider to purchase, and then discontinue, their own customers' annuities".
Mark Duke said: "For small annuities, the original provider may be able to offer the best price as it knows it would no longer have to administer the annuity or hold capital against it. It's not obvious whether the original provider would be allowed to buy the annuity after someone else has taken their cut or why the Government doesn't want them to buy it directly. Is it worried about the bonds backing annuities being sold? If it just wants to ensure that individuals get competitive quotes, it could still allow the original provider to bid against others.
"As well as insurers, some defined benefit pension schemes could consider buying second-hand annuities. This would offer some protection against longevity risk but it would hardly be a perfect matching asset – the payments would track different lives, would not have the same inflation protection and would have different spouses' benefits. So far, defined benefit schemes have been much more interested in bespoke longevity hedges that pay out based on how long their own members remain alive. Depending on the price at which annuitants are willing to sell, second-hand annuities could even be considered a return-seeking asset
"We expect that intermediaries would look to buy annuities individually, package them together and sell them on in bulk. The ultimate investors would need to have confidence in how the middle man assessed people's health, and the costs of medical assessments would eat into what sellers receive. These pools of annuity income could be compartmentalised in various ways – for example, different buyers might want annuities from people of different ages or health status, or some might consider paying more to get whichever income streams continue for longest."
A £155+single-tier State Pension?
The new single-tier State Pension will apply to people reaching State Pension Age from 6 April 2015.
David Robbins, a senior consultant at Towers Watson, said: "The starting level of the single-tier pension won't be officially confirmed until the autumn, but the Chancellor might prefer to unveil its likely level before the election.
"The Autumn Statement said that the single-tier pension will be at least £151.25 a week. This is 5p above the tested minimum income guaranteed through Pension Credit in 2015/16. With the same 5p-a-week gap, it's hard to see the single-tier pension being any less than £154.15 in 2015 – and it will be higher if earnings growth is 2% or more***. If the Chancellor has a little money to spend, he could announce that it will be at least £155."