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Defined Contribution Schemes - changes in pension indexation
Introduction
The Child Support Pensions & Social Security Act 2000 will allow greater use of investment-linked annuities for members of defined contribution pension schemes. The Bill has been passed by the House of Commons and is currently before the House of Lords. The changes will come into effect once the Bill is passed later in the year.
Background to pension indexation
In a defined contribution scheme, at retirement, a member's accumulated pension fund is used to purchase an annuity. There are a number of restrictions on the types of annuity that may be purchased for different parts of the accumulated fund.
Prior to April 1997 the only restriction (beyond those laid down by the scheme) was for schemes contracted-out of the State Earnings Related Pension Scheme ("SERPS"). For these schemes an annuity purchased with protected-rights funds built up between April 1988 and April 1997 must increase at a minimum of Retail Price Inflation subject to a maximum of 3% in any one year.
The Pensions Act 1995 introduced greater restrictions for occupational schemes. For all funds built up after April 1997 (with the exception of Additional Voluntary Contributions) there is a requirement to purchase an annuity that must increase at a minimum of Retail Price Inflation subject to a maximum of 5% in any one year. This is known as Limited Price Indexation, or LPI. For personal pensions this requirement was limited to pension in respect of post April 1997 protected-rights.
It is our view that these new conditions were too restrictive and in particular we were disappointed that the conditions for occupational schemes were more restrictive than for personal pensions.
Traditional and investment-linked annuities
Annuities are a financial product sold by life insurance companies. In return for a single premium, a traditional annuity offers a guaranteed income for life. The income may be flat, increase at a specified fixed rate, increase in line with price inflation or increase in line with price inflation subject to a cap. The annuity may also continue the pension to a surviving spouse usually at a reduced level.
In order to guarantee the income the life insurance company is required to invest the premium mainly in "matching" gilt-edged securities. The price of these securities at the time of purchasing the annuity therefore has a large impact on the level of annuity that can be offered. There has been much talk in the press over recent years about the high cost of annuities - this partly reflects the high cost of long-dated gilt-edged securities due to
- expectations of low interest rates over the long-term
- the increasing demand for these securities from pension funds has not been matched by increased supply - the Government has been reducing new debt issues
Investment-linked annuities offer an alternative to the traditional annuity product. An income is still guaranteed for life, however the level of the income varies to some extent depending on investment returns - the income may fall as well as rise. As the level of income is no longer guaranteed, the insurer is able to invest in other investments such as equities - over the long-term the real return from these assets are expected to be greater, and if so the pension income will grow correspondingly.
Investment-linked annuities are a small but growing market. The majority offered at the present time are "With-Profit" annuities which offer some smoothing to investment returns, however there are also a number of "Unit-linked" annuities being offered where there is direct exposure to the underlying investments.
The proposed changes for defined contribution schemes
The Government proposes to allow investment-linked annuities as an alternative to LPI annuities for post-April 1997 pension. At the current time this relaxation of the rules will not extend to protected-rights, however this is being considered for the future. At this stage it is unclear whether there will be any restrictions on the type of investment-linked annuities.
We welcome this new flexibility. However investment-linked annuities will remain inappropriate for many people and this is an area where most individuals will need advice.
James Harrington, May 2000.