Employers can help staff choose their annuities but there are risks in doing too much, says Nicola Sullivan
Employers that have gone to great lengths to promote the value of saving into occupational pensions to their staff may also be keen to ensure employees select the right annuities. On reaching retirement, members of defined contribution (DC) schemes usually have to use all, or part of, their pension pots to purchase an annuity. This is a contract under which an insurance company agrees with an individual scheme member to pay an income to them for the rest of their life.
However, there is a danger that employees will simply select the annuity offered by their existing pension provider without shopping around for better annual payout rates as they are entitled to do under what is called the option market option (OMO). This was recognised last May, when the Pensions Regulator demanded an improvement in the level of knowledge and practice shown by employers when it comes to helping staff understand the types of annuities available.
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If employers do not provide some level of financial education around annuities then things could turn sour. Tom McPhail, head of pensions research at Hargreaves Lansdown, says: “The last thing an employer wants is a former employee coming along two years later saying ‘because you [the employer] didn’t tell me about these options I bought the wrong kind of annuity.”
Where employers opt to leave the issue of annuities up to individuals then they could make provision for some financial advice to be offered by a third party. Mick Calvert, head of the financial planning group at Watson Wyatt, says: “If employers take the view it is not their problem because employees are retiring, they would be better off putting less money into the pension scheme and using the money they save on paying for some impartial education.”
The best time to begin educating employees about annuities is five years before they reach retirement. At this point, employers should concentrate on providing specific information about the types of annuity that are available. This is particularly important because employees who select the wrong annuity could lose out on as much as 30% on their retirement income, says Calvert.
The methods employers can use to deliver this financial education vary, with some simply providing information leaflets and DVDs, and others recruiting independent financial advisers (IFAs) to come in and talk to staff about their options. Employers that do not want to shell out for independent financial advice could opt to offer free sessions provided by representatives from annuity providers. However, Alan Marks, group managing director at Templar Financial Planning, says they should be aware that such sessions are likely to be run by salesman on commission so their advice could be skewed.
Employees should be informed of their right to exercise the OMO. Since 2001, insurance companies have been obliged to tell policyholders they are free to buy a policy from any insurer and do not have to take the one offered by their existing pension provider.
But shopping around to get the best deal is no easy task. Whereas once annuities were based solely on gender and age, some are now based on life expectancy which means employees who are smokers or have existing health conditions are more likely to secure competitive deals.
Some annuities even take into account where employees live because an insurer has deduced that those living in certain areas have a lower life expectancy. Employees can also select annuities which provide them with a guaranteed monthly pension with increases along with the rate of inflation.
Another popular option is level annuities, which pay the same rate for life. Meanwhile, annuities with a guaranteed period pay out retirement income for a set number of years even if the person dies before the end of the policy. Alternatively, escalating annuities provide an income which normally starts at a lower rate and then increases each year.
Employers should also ensure staff are aware of both single and joint life plans. For example, some employees may opt for an annuity that guarantees their spouse will receive an income if the policyholder dies first. Staff also need to be educated about the risks involved with investment-linked annuities, linked to stocks and shares.
One way of helping employees to select the best annuity for their circumstances is to provide access to online tools that help staff to compare products after they have entered their personal requirements.
Employers also have an obligation to let employees know they do not have to take out an annuity at all. Employees can opt for a drawdown arrangement whereby income is drawn out of a pension fund invested in the stock market. Although risky, this gives members more control over their income. On reaching 75 years, employees have to either purchase an annuity or convert the value of the income drawdown fund to an alternatively secured pension (ASP) plan.
But while financial education should help to eradicate a workforce’s misconceptions about annuities, David Bird, principal at Towers Perrin, says employers should not take full responsibility for employees’ annuities.
“Employers doing too much can be a little dangerous,” he says. “It does not get across the message to employees that annuities are their personal responsibility.”