'Purchased Life' Annuities

Milarky

I understand the concept well enough [see this old write up about them] but my line of thinking is whether this is a superior use of the tax free lump sum to generate income compared to the alternative, as I see it, which is to use up the lump sum to vest into another pension?

As we now know 'recylcing' of unvested pension fund monies is to be outlawed after A Day, but there is still scope to effectively use some or all of the '100%-of-income' rule on contributions in final years to do this...

Anyway, for a basic rate taxpayer it is theoretically possible to turn a fund value of £100K [with £25K earmarked as 'tax free'] into one of £110,377, all of which has to be taken as income. [The exact ratio is '234/212'*]

If you took £75K to buy a compulsory pension anniuty and £25K to buy a purchased life anniuty with, the article says that a large proporiton of the latter's 'income' is paid out tax-fee - since it is deemed to be return of the annuitant's own capital. It also says that comparable 'gross' rates on these annuities are somewhat lower than on the compulsory anniuities [making the point that the insurer is 'selected against' by basically 'healthy' people who would live longer than the 'average' of the population]. What surprised me was the relatively large element of income which is treated as return of capital - between 71% at 60 and 94% at 80 - which leads to particularly low incidence of tax. [And the basic tax rate is a bit lower, too, at 20% rate than 22%]

My point

Option A gives about '110%' less 22%[tax], or about '85%' as a net income of the quoted complusory pension annuity [85% of the 'gross' in other words]

Option B only has 75% to buy a pension with and that is reduced by 22%. This leaves the annuitant in the position of having only '58.5%' with a quater of the fund available to raise additional income from.

'85%' - '58.5%' leaves '26.5%' which is more than the 25% available. Thus it seems that even with 'no' tax a purchased life anniuty could not match this return [and there is always some tax, however low, taken from the payments] since, as stated, they can't pay as high a rate in the first place.

*the formula for this is: [3/4] of [100%-relief]/[75%-relief]. For 22% rate taxpayer that becomes

[3/4] x [100-22] /[75-22] or [3/4] x [78/53] or [3 x 78]/[4 x 53] or [234/212]

40% taxpayers would have a comparable ratio of '180/140' or '128%'. Their 'gap' [what the 25% lump sum needs to raise in additional income] stands at either:

128.57% x 78% - 75% x 78% [if they are 'basic rate' in retirement] OR

128.57% x 60% - 75% x 60% [if still 'higher are' in retirement]

In either case a purchased life anniuty would have to be 100% tax-free and pay a much higher interest rate to come anyway close, since the effect of this uplift [raising '100%' to '128%' potentially] is to increase the reference amount of 25% to 53% - a doubling.

[So what scope 'recycling' given that it can't be done all in one tax year? phased 'drawdown', whilst still working f/t over serveral tax years using the lump sum released towards the '100%-of-income' rule?]

EdInvestor

Why not just buy an investment bond and be done with it, if you like that kind of product :rolleyes:

Milarky

Ed,

I was trying to get my head around the alternative uses of the lump sum. The logic of 'recylcing' is that the the cash is converted [using the additional tax relief available] to an 'income-only' condition. Given you sign up to using 75% of your assets this way when taking out a pension, anyway, it is legitimate to consider that you will be seeking to maximize income thereafter. Any capital you don't spend you effectively 'park' and draw an income from it. [Then there's the old chestnut about not spending 'all' the income since some of it represents inflation!]. Pensions push you the other way - towards drawing an income etc [.i.e. 'bye-bye' capital!] Not a bad thing.

Anyway, I'd already worked out that you get an extra 10% potentially as a basic taxpayer if you could go down this route [and, effectively, I belief you still can, just in a more 'planned' way than those press items were suggesting doing it]. I had thought: "10 percent is not much for giving up your capital is it?" But the point above is that it is actually more like '40%', since the thing that would be generating the additional income - the lump sum - is only a quarter of the pot. That's for a basic rate taxpayer. For higher rate [going in] it is more like an extra "100%" [ 28.57% added to 25%: 53.57% buying an income instead of 25% buying an income with certain tax advantages]

So I feel this idea [of 'precycling', I suppose you might call it - making 'excess' pension contributions ahead of retirement using the 100% of income allowed to the tune of the theoretical tax relief available] is worth considering in light of those alternatives [for income generation] such as the PL annuity or the investment bond you mentioned.

Pal

I do not have time today to read the above posts in any detail, but I will throw in one issue that you need to consider: Just about everyone with a pension buys an annuity, however only people in good health who expect to live a long time buy a purchased life annuity with non-pension scheme money. As a result annuity rates are often worse than pension annuities.

ReportInvestor

Pal wrote:

Just about everyone with a pension buys an annuity, however only people in good health who expect to live a long time buy a purchased life annuity with non-pension scheme money. As a result annuity rates are often worse than pension annuities.

dunstonh_in_July_2005 wrote:

Assuming compulsary purchase annuity and Non smoker, you can get £7483 on 100k. Probably a little more with a bit more research. A purchased life annuity would be a little more.

So have things changed since last Summer or have I got the wrong end of the stick?

Pal seems to be correct.

http://sharingpensions.co.uk/pension_annuity9.htm

"The purchased life annuity market is not as developed as the compulsory purchase annuity (pension annuity) market so the income from the same size of lump sum is less, usually between 80% and 90% of the pension income. Also the insurance companies believe that because there is no compulsion to buy a purchased life annuity, as there is with a pension annuity, they are going to be selected against. In other words, only healthy people would buy a purchased life annuity and therefore this will reduce the mortality profit in this market and therefore reduces the rates offered.

Despite this lower income, the annuity taxation of a purchased life annuity is very favourable compared to pension annuities and it provides a higher income net of tax. This means that the majority of individuals on retirement that want to maximise their pension income should commute the maximum tax free lump sum and use this for a purchased life annuity."

EdInvestor

AFAIK the attraction of PLAs revolves around age.

The question of how to generate the best income from a pension fund's tax free cash is probably IFA 101, I guess :D

But there are so many variables that it's impossibe to say without going through them.

Perhaps we should - it would make a good discussion.

Pal

ReportInvestor: From the quote you have provided it seems that both Dunston and I were correct.

My point was only that the difference in annuity rates would throw out the calculations in Milarky's original post. Unfortunately it is not just a comparison of post tax income.

Milarky

Here's my attempt to flesh out the bones, by way of a numerical example [figures are taken from the annuity tables given by the source]:

For a 65 year old male basic rate taxpayer [paying in and in retirement] buying level annuity, and a nominal fund of £100,000 [Very nominal, I agree!] he gets a £25,000 tax free payout plus a gross income of £5328 [75% of '£7104']. He can invest his £25,000 in a PLA and get a gross income from this of £1718 [25% of '£6870' slightly less as previously stated]. He pays tax on his two incomes as follows:

£5328 @ 22% = £1172

£1718 @ 3.36% = £58

So his total net income is £5328 plus £1718 minus £1172 minus £58 or about £5816

His alternative approach means converting his £25k [via precycled earning-years payments] into a much larger pension, whose own larger lump sum must then be used to replace the additional payments made plus the 'interest' on these payments.Thus he 'forgoes' the lump sum as soon as he recieves it. 75% of his fund is now valued at £110,377 and he buys a conventional annuity based on this instead.

That is:

110.377% x £7104 minus 22% tax - a net income of £6116

'£6116' is about 5% greater than the '£5816' derived from the joint compulsory/purchased life route.

If he were a higher rate taxpayer paying in but basic rate in retirement [his best combination], 75% of his '100k' fund would be £128,571. That is over 16% more than in the previous example, so that his pension would be

128.571% x £7104 minus 22% tax - a net income of £7124 - relative increase of 22% compared to £5816

An alternative way of looking at these examples is to say that, whilst his PLA generates a net income for him of £1660 based on a nominal value of £25k [that's 6.64%], he could get £300 a year more in the first case - equivalent to '£1960' [or '7.84'%] - as a basic rate contributor OR £1308 a year more - equivalent to '£2968' [or '11.87'%] as a higher rate contributor.

[Phoaww!! Getting nearly 12 percent on your money - that's like living in the early 90s again!]

EdInvestor

AFAIK that's why PLAs are not normally considered until people are considerably older than 65 - and even then the money tends I suspect to be held onto by many, in case it needs to be put towards an "immediate needs annuity" to fund long-term care, where the income is tax-free if paid to the care home, and many people do want the "insurance policy" aspect of ther annuity .

I guess you must be planning to live a long time milarky, with this great interest in sacrificing capital for income, even though the income is subject to the whims of the taxman?

caveat_emptor

Milarky wrote:

His alternative approach means converting his £25k [via precycled earning-years payments] into a much larger pension, whose own larger lump sum must then be used to replace the additional payments made plus the 'interest' on these payments.Thus he 'forgoes' the lump sum as soon as he recieves it. 75% of his fund is now valued at £110,377 and he buys a conventional annuity based on this instead.
[Phoaww!! Getting nearly 12 percent on your money - that's like living in the early 90s again!]

Can Milarky or anyone else explain how the original capital sum of £100,000 becomes £147,169.
Thanks
Cav

Milarky

caveat_emptor wrote:

Can Milarky or anyone else explain how the original capital sum of £100,000 becomes £147,169.
Thanks
Cav

Hers's how it works:

----Pension[75%]

---

Lump sum[25%]

---

Total[100%]
......75,000.00................25,000.00................100,000.00

Take the lump sum and 'vest' it to an immediate pension
25,000.00 + 22% tax relief = 32,051.28
75% of this goes into 'pension' only form, and 25% into 'lump sum' form. So we now have:

----Pension[75%]

---

Lump sum[25%]

---

Total[100%]
......75,000.00..............ex 25,000.00................100,000.00
......24,038.46...................8,012.82..................32,051.28

The previous lump sum is now gone [into the next stage pension] hence the 'ex' before it. This is now a 'pension' of 99,038 plus a [reduced] lump sum of 8,012. The process is repeated infinitely until the lump sum is reduced to 'nil'

After another two stages, for instance it would look like this:

----Pension[75%]

---

Lump sum[25%]

---

Total[100%]
......75,000.00..............ex 25,000.00................100,000.00
......24,038.46...............ex 8,012.82..................32,051.28
........7,704.63...............ex 2,568.21..................10,272.84
........2,469.43.....................823.14...................3,292.58

with a 'pension' of £109.212 [from adding up the first column] and a residual lump sum of £823 only. The whole pension fund is actually valued at £145,615 but remember that additional amounts of: '25,000' '8,012' and '2,568' have all had to be put into the already existing fund [of £100,000]. Under the newly announced 'A Day' rules in the Pre Budget Statement these amounts can't come from the lump sum of a pre-existing pension before that lump sum is finally released [upon retirement] . These payments have to come from somewhere 'else' therefore. If you total them up they come to '35,580'. One quarter of the enlarged fund [36,403] is just about enough to to cover them -and that's the point: making the fund larger to 'extract' the full value of the lump sum plus the maximum tax relief available from it. The 'gain' is the added tax relief and a larger total pension 'pot' - the 'loss' is the freedom of the 'lump sum' which must be used to replace all those additional 'precycled' payments.

What has changed is that this exercise can't be carried out 'in a rush' since the Chancellor has said that recylcing lump sums merely to obtain the tax relief is an 'abuse' and he won't allow it as it seemed a few weeks ago that he might have. What hasn't changed is the arithmetic - based on the rate of tax relief available [22% or 40%] - which allows one to build up a bigger pension in the 'normal' way by larger payments [he's going to allow you to contribute up to 100 percent of your earned income each year, for instance]. The remaining 'risk' in this approach, however, is the assumption that the 25% tax free lump sum will always be available at retirement. That could change [but it's highly unlikely it would with as little as the four months notice the Chancellor gave of his u-turn on sipps, for instance] if for no other reason than many people will have earmarked their lump sums or possibly taken out loans against them [unofficially] and to scrap the lump sum would upset too many people's plans as it is.

This thread was, though, trying to see whether it would be genuinely worthwhile boosting the pension at the direct cost of the lump sum. The logic being that the lump sum would not be required to meet other commitments and so would only be used to generate income. [That's an important qualification, so probably won't apply to a larger number of people]. If that were the case the simplest option would be to stick it in a deposit/savings account and live off the interest. The alternative approach takes one towards the 'purchased life' anniuty which - because it is effectively a 'whole-of-life' loan to an insurance comapny pays out an income which is part 'interest' [on which you get taxed] but mostly 'capital' [which is therefore paid free of tax]. This tax 'advantage' of the PLA must be set against the [different] advantages of a [compulsory] annuity - which is that it can be 'bought' with tax-relieved contributions - and would therefore lead immediately to a rather larger fund - and also [as was pointed out above] is likely to pay out at a higher rate because the 'pool' of people buying such anniuties is less selective and so the people from that pool will on average live less time and need to be paid for less time than the pool of people likely to buy a PLA.

Complicated it is, I know, but the 'icing' was in the calculation which showed that it is marginally beneficial only to a basic rate taxpayer to contemplate this but much more clearly advantageous to a higher rate taxepayer to [take the time and trouble to] do this on the assumptions that:

a) they will have sufficient other capital as to not be reliant on their lump sum
b) that the lump sum will remain available [highly likely but not certain]
c) that their [marginal] income in retirement will be lower [i.e. they will become basic rate taxpayers]

HTH