"Victory for pensioners hit by tighter drawdown cap" was just one of the headlines in the national press following the announcement in the Chancellor's Budget Statement in December that the Treasury plans to reinstate the 120 per cent (of GAD rates) maximum income limit for income drawdown.
At the time of writing there is still no more detail on the changes and the timeframe for their introduction. While this latest U-turn in government policy on income options at retirement is to be welcomed I worry that it may lead the Government to resisting demands for a much needed more wide ranging review.
Despite its relatively short lifespan there are few areas in the world of pensions which have been subject to more legislative change and political and regulatory interference. By my reckoning the latest announcement is the fifth attempt by successive governments to find an acceptable method of determining how much income can be taken each year – and every time GAD rates have been involved. I continue to be concerned by the continuing link with annuity rates in determining maximum income levels.
I've been involved with income drawdown since its introduction in 1995 and I'm often asked why GAD rates were used for determining maximum income levels. To understand this link with annuity rates you have to go back to the early nineties when there was considerable pressure for a relaxation in what until then had been a very inflexible Treasury approach to the drawing of benefits from individual pension plans. Basically the only option was a compulsory purchase annuity. For many it wasn't a very attractive option. Indeed I recall one of my colleagues at the time describing annuities as "the last bastion of insurance company conservatism." Over 20 years later maybe that description still has some validity.
It's hard to believe but in October 1990 annuity rates were over five times current levels, 15 year gilt yields were close to 12 per cent and the FTSE 100 index stood at just over 2,000. Despite the level of annuity rates there was growing disquiet at the lottery that applied around the timing of the purchase of an annuity – which could make the difference between a comfortable standard of living in retirement and merely getting by.
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It was against that backdrop a few companies tried to break the mould. Two in particular that spring to mind are Equitable Life who launched a managed annuity and Provident Life who tried to launch a flexible annuity. Maybe it isn't a surprise that neither company exists today although Provident Life morphed into Winterthur Life which in turn became part of Axa and today is Axa Wealth. At the time I was working for Provident Life and was closely involved with the flexible annuity. As the marketing literature said it freed "annuitants from the straightjacket of a fixed income by allowing scope to vary the frequency, timing and size of annuity payments". It provided several different ways for annuitants to provide for their dependants after death and through the use of a "private fund" facility it allowed annuitants to invest directly in a wide range of assets – similar to a Sipp.
Unfortunately Treasury thinking wasn't as enlightened and it decided to ban the flexible annuity on the grounds that it didn't meet the previously unpublished criteria for an annuity of being "safe, stable, regular and for life". That was a huge blow for both Equitable Life and Provident Life and caused uproar amongst many advisers and their clients. I know that over 1,000 advisers actually wrote to their MPs protesting at the decision.
As a result the Government came under great pressure in 1994 to reform the relevant pensions legislation. The consultation process was relatively informal – I recall making two trips to Number 10 to discuss the topic with the Prime Minister's advisers – and the Treasury struggled to find a satisfactory alternative. However eventually in the summer of 1995 the first drawdown regime was announced – with a maximum limit of 100 per cent of GAD rates and a minimum of 35 per cent. I have little doubt that the link to annuity rates reflected the Treasury's reluctance to acknowledge any viable alternative to annuities. I believe that view is still held today by some Treasury officials – and I am sure is also behind some of the FSA's pronouncements on the subject.
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Before leaving the flexible annuity that wasn't an annuity it's worth looking at some of its proposed features. It had a minimum purchase price requirement of £150,000 and if the fund at any time fell below the level required to secure the minimum income (see below) it had to be automatically converted to a conventional annuity. Had those provisions applied to income drawdown then maybe some of the "misselling" concerns that have arisen over the years would have disappeared. It also required a minimum income of £7,500 per annum to be taken each year and it could be converted into a conventional annuity at any time. Those provisions were with the aim of ensuring it was deemed to be an annuity – unfortunately it wasn't enough to satisfy the Treasury lawyers.
It provided three death benefit options:
a. The remaining fund on death could be paid in full as a final one-off annuity payment subject to income tax; b. The flexible annuity could continue to be paid to a surviving spouse or dependants;
c. The flexible annuity could be converted to a conventional annuity for the surviving spouse or dependants.
Of course none of these options actually materialised.
However I believe that these pioneering annuity products may have led to the legislators misguidedly viewing their replacement - income drawdown - as an extension to annuity options rather than as a real alternative to the safety and security that an annuity provides. Why else would you base income limits on a proxy to annuity rates? For most of drawdown's lifespan the legislative and regulatory focus has been on risk – but with much greater emphasis on the risk of depleting funds prematurely through excessive income drawings rather than on investment risk and in particular the risks posed by longevity or particularly adverse timing of investment returns.
This last point is crucial. For example take a 65 year old client with a fund of £100,000 and taking income at £9,000 (clearly above current maximum levels). Assume that the average annual return is six per cent per annum. Then some simple modelling assuming very different sequences of annual investment returns but averaging six per cent per annum overall can lead to the fund running out as early as age 81 or as late as age 95 – a 14 year gap. Basically strong investment returns in the early years will extend the lifetime of the fund whereas poor performance early on will have the opposite effect. That is a point that is not always appreciated by critics of income drawdown. Successive layers of legislation have also contrived to make the operation of income drawdown far more complicated than is actually needed. The 2011 reforms provided an ideal opportunity to sweep away many complexities but that opportunity wasn't taken despite industry consultation. Instead we continue to have reams of regulation – the baffling world of benefit crystallisation events being a good example of this. The reinstatement of the 120 per cent limit is to be welcomed. However there have been other more radical and, in my view, enlightened proposals which involve breaking the link with annuity rates – and instead designing a simpler and more imaginative regime where annual income limits are determined by length of time to a certain age – say 90.

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