Enhanced annuities often provide a higher pension income from the pension savings of those whose lifestyle choices or medical history make it likely that they will not live as long as healthier annuities purchasers. Enhanced annuities are structured to provide a higher payout, as it is likely that they will not have to pay for as long, based on the reduced life expectancy of the annuitant.

Enhanced annuities are particularly associated with smokers, and those with high blood pressure or high cholesterol. This type of pensions annuity is usually allocated on the basis of a points system, with no medical examination required. However, with some companies the points system means that enhanced annuities are more usually offered to those with 2 or more of the conditions mentioned above.

Annuities provider Towers Watson noted sales of enhanced annuities totalling £582m in the first quarter of 201o, a new quarterly record which was then smashed by even better record sales of £676m in the second quarter.

Towers Watson also indicated that enhanced annuities, which were introduced in 1995, now account for a third of all annuities sold in the UK.

With the average wage, as of March 2010, pegged at £24,000, this means a pension income that constitutes a drastic reduction in ‘buying power’ for the average worker.

UK pensions specialist Partnership’s estimates showed that 9 out of 10 retirees over the last 5 years had pension savings of £50,000 or less, and 8 in 10 (77%) had pension savings of £30,000 or less.

The latter group, based on currently low annuity rates of 6-7%, could expect an annual income from that of around £2,000 per year. Those entitled to the full Basic State Pension can add to that £6,000 including earnings-related top-ups, giving an annual pension income for 80% of retirees of £8,000 (although this may be supplemented by some pension credits, according to circumstances).

Pension income also lost by those in imperfect health

The situation is worsened by the fact that 4 in 10 retirees have less than perfect health** or lifestyle, but are unaware, in their pensions planning, that they can boost their pension income by up to 40%, by purchasing an enhanced annuity.

Insurers pay more to those who are expected to die sooner, due to health or lifestyle issues, by providing an enhanced pensions annuity. Despite this, those who are overweight, smoke, have high blood pressure or another ailment are often not informed of the enhanced option, when purchasing their pensions annuity. While people in the ‘unhealthy’ bracket represent 40% of those retiring, only 1 in 4 of them actually purchased an enhanced annuity in 2009. The other 3 in 4 lost out on thousands of pounds of pensions income.

For example, based on a man of 65 with pensions savings of £100,000, a standard annuity would give him annual pension income of £6,669 per year. However, if he declared he was a smoker, an enhanced annuity would raise this to £8,028 per year**.

*Source: Association of British Insurers ABI    **Source: Hargreaves Lansdown

Thanks to the pension changes, many will appreciate the freedom to base their pensions planning on retaining their own pension savings, rather than cashing them in to buy a pensions annuity. They can now leave their pension savings invested, and as they have not handed their pension pot over to an annuity provider, they can leave what remains of their pensions savings to their children, in their will.

However, under existing legislation, this course of action could expose their pension savings to a combination of tax charges that could eat up to 82% of their funds, when they die. Over half of this consists of tax and other surcharges that would be levied on their savings as an ‘alternatively secured pension’. This is the term that refers to a pension held without an annuity purchase for those over 75, and for most is a continuation of their previous unsecured pension.

In many cases the alternatively secured pension will be an income drawdown contract, where pension savings are left invested in the stock market, and can be drawn down in different amounts each month, as required.

However, the remainder of the tax which could be due on pension savings left to the children as part of the saver’s pensions planning would be Inheritance Tax (IHT), which is levied by HMRC at 40% on any funds which exceed the individual’s ‘nil rate band’ allowance of £325,000 (or $650,000 for a couple).

While the nil rate band may sound relatively generous it includes all wealth contained in the individual’s estate, and many find their allowances quickly disappearing when they tot up the value of their property, life and other insurances, savings and investments, and the pension itself.

By taking pensions advice, portions of this tax liability and in particular the exposure to Inheritance Tax can be reduced, or eliminated altogether. Pensions savers can put in place an effective programme of pensions planning by working with a qualified independent financial adviser, in response to these and other Government pension changes that may emerge, over the coming weeks.

Dig a little deeper, and we see that the pension changes are primarily designed to save the state money – which of course is the Government’s job, and must be applauded. However, looking at the pension changes with a cynical point of view does give a unique perspective on government pensions thinking in general.

Basic State Pension and pensions credits: The Government will say that the launch of the National Employment Savings Trust (NEST) in 2012 will provide everyone with an additional pension income, a private pension in addition to the Basic State Pension which currently pays out just £97.65 taxable per week. A cynic might point out that it will also save the Government paying out means-tested pension credits as a top-up to the Basic State Pension, since now we will all have a personal pension pot of our own from our NEST pension savings. In other words, the Government has had us save our own pension credits, and will soon need to pay far less pension credits from the coffers of state.

State retirement age and NI contributions: Government will say that raising the state retirement age to 66 gives employees more flexibility to work longer, which suits a generation whose improved health and longevity has dubbed them ’the wellderly’.  A cynic might say that Government has also cleverly had us pay into the Basic State Pension for longer, with an additional year of National Insurance contributions, and also to draw the Basic State Pension for a year less, as we will retire a year later.

The 75 rule versus tax liabilities: Government will say that by abolishing compulsory purchase of a pensions annuity by age 75, we now have greater flexibility to keep our pensions savings, and to bequeath them to our children. However, a cynic might point out that after the government pension changes, the taxman at HMRC may be rubbing his hands with glee at the prospect of Inheritance Tax and other tax liabilities - these could eat up four-fifths of our pension savings, if we leave them in our will without taking pension advice and discussing retirement planning.

Assuming that we will be served some kind of pensions cocktail based on the pre-election pledges of both Con and LibDem, there are several areas where the parties bring the same views to the table, with regard to pensions and the Basic State Pension in particular.

The Conservative Party has been talking about an emergency budget within 50 days of forming a new government, which would imply before the start of July. If the LibDems agree to this, then here are the changes for pension savings, and the Basic State Pension, that the budget is likely to contain.

Link Basic State Pension to earnings: Both David Cameron and Nick Clegg are united on re-linking the Basic State Pension to earnings. This is a ‘stop the rot’ measure designed to halt the gradual decline in the buying power of the Basic State Pension, since it was linked to the Retail Price Index by Mrs. Thatcher in 1979. The link to earnings should keep the Basic State Pension ahead of inflation, as earnings tend to increase faster than prices. The deadline for achieving this link is a little vague, however. The Conservatives have said only that it should be done during the lifetime of this parliament.

Cancel compulsory annuity purchase by age 75: Pension savers are currently required to use their pension savings to purchase a pensions annuity when they retire. They do not need to do this immediately, but it must be done before they turn 75. Both parties in government have been in agreement that this requirement should go, opening the way for pension savers to avail for longer of such options as income drawdown, where they can leave their pension pot invested in the stock markets, taking income only when they need it. A key advantage of income drawdown is that you remain the owner of your cash, rather than spending it on a pensions annuity. This opens the door for pension savers to retain their pension savings beyond their 75th year, and leave their pension savings to their loved ones, in their will.

Changing the minimum retirement age: Both parties seem to agree that the state pension age should be changed to reflect increasing longevity in society. Conservative thinking would raise the state pension age to 66 for both genders, first for men in 2016, and in 2020 for women.

Several months before retirement, most pensions savers receive an information pack from their pensions provider informing them of the regulations governing pension income. While they are correctly informed that they may take 25% of their pension savings right away as a tax-free lump sum, and that they have the right to defer purchasing an annuity until they are 75 if they wish, the arrival of this literature gives many the impression that they are required to buy their pensions annuity from their existing pension company.

This is not the case; in fact, pensioners are given the right to compare annuities freely, considering the whole market. We shop around when buying a car that will last us perhaps 10 years; how much more important to shop for your pensions annuity, which will be an ‘all of life’ decision, and largely dictate your quality of life in retirement!

Taking as an example figures for December 2009, a simple search for an annuity from a pension pot of £100,000 flagged up products providing vastly different monthly incomes. Simply by shopping around, annuities were available from Canada Life paying £5,628 per year, down to a Scottish Widows annuity paying £4,632 per year.

With one simple search, it was possible to find an annuity that added £996 per year to your retirement income!

Most important when shopping around for any financial services product is to use an independent financial adviser, whose whole of market approach ensures that all available products are considered, when searching for the right annuity for you.

For pensioners who have not yet purchased an annuity, or have an income drawdown arrangement with their pension still invested in the stock market, or those retiring in the next 2 years, the consequences of this announcement are clear.

Consulting a financial adviser to look urgently at purchasing a pensions annuity, before rates undergo this radical fall, is essential.

The fall in rates will be a by-product of the Brussels initiative ‘Solvency II’, which aims to reduce risk for large pensions companies like Prudential and Aviva, by requiring them to hold back more capital in their reserves, specifically to meet their annuity pay-out liabilities.

This requirement to hold back more capital will mean reduced payments to annuity holders, sparking the fall in annuity rates.

Planned increases in the state pension age are likely to lead many to use income drawdown in their retirement planning, as they seek out ways to tap into their personal pension before they reach state pension age.

Changes in state pension age

The state pension age is now 65 for men and 60 for women.

For women it will rise to 65 between 2010 and 2020. Then it will rise, for both sexes, to 66 between 2024 and 2026, to 67 between 2034 and 2036, and to 68 between 2044 and 2046.

These rises could be introduced sooner, depending on the outcome of the general election, as the Conservatives have expressed a desire to push forward change as quickly as possible.

As a result, those wishing to retire early may have several years to fund themselves, in order to bridge the gap until the state pension becomes available to them.

Income drawdown

With this end in mind, many may consider income drawdown as an alternative to the traditional annuity, which is available for ten years, until the purchase of an annuity becomes compulsory at the age of 75.

With income drawdown your savings remain invested in the stock market, making it a more risky strategy than purchasing an annuity right away.

Additionally, there are several other important issues to consider, before taking the income drawdown option.

With income drawdown, you can take or drawdown larger amounts from your pension savings, compared to what you would have had from an annuity payment. You can also choose to take lesser amounts, or none at all from time to time, making this a good option for those who are continuing to work part-time, for example.

With income drawdown, your income is taxed on a PAYE basis. However, your pension remains your money, and can be left to your family if you die, whereas if you had bought an annuity your money would become the property of the insurance company.

With income drawdown, you are dipping into your pension pot. This means that, if you draw down more than the yield from your investments in any given year, you are eating into the capital in your fund. This is why, in recent years, many pensioners who drew freely on their savings as stock markets were in decline were eroding the total amount of their retirement savings.

An ‘Immediate needs annuity’ is designed to provide the costs of paid-for nursing home care for life, for those already suffering from physical or mental disability, and who are no longer wishing or able to live at home. 

The annuities are bought with a lump sum, but can now offer a guaranteed partial payback if the person in care dies within a short time of buying the annuity. 

The facility is designed to alleviate the fears of customers or relatives who hesitate to invest so large a sum, when the person to be cared for may live for only a short time, after the purchase of the annuity. 

AXA offers 3-month or 6-month insurance guaranteeing 25%, 50% or 75% payback on the annuity, according to Brian Fisher, LTC marketing manager. 

The shorter-term options of just 3 or 6 months are the key to making the cover affordable to the customer, Fisher said. 

“Our 6-month, 75% cover can typically add just 5% to the cost of the annuity,” Fisher said. 

“That compares with the cost of long-term, 75% payback protection, which can add as much as 40% to the cost of the annuity, because you are insuring the lives of very old, very sick people.” 

One restriction on the guarantees is that the benefit cannot go outside the estate of the annuitant, for Inheritance Tax purposes, he said. 

Partnership is another provider which introduced the guarantees on its annuity products earlier this year, and offers a payback if death occurs within the first six months of the policy. 

With Partnership’s guarantee, the purchase price of the annuity will be repaid in full if death occurs within 1 month after buying the policy, 50% will be repaid if death occurs in months 2 and 3, and 25% will be repaid if death occurs in months 4, 5 and 6. The costs of payments already made to the nursing home will be deducted.

Recent events in the stock markets have made it clear how essential it is to get the timing right, in this vital aspect of your retirement planning.

The recent volatility in the stock market has been reflected in similar ups and downs in the value of pension funds.

As a result, during 2009, the flexibility to choose the right moment for buying your annuity could have meant an extra 18% in your retirement income – that’s an extra 18% per month in your pocket, for life! 

One answer is ‘income drawdown’

The good news is that you do not have to purchase your annuity right away, when you retire.

You can take your lump sum of up to 25% of your pension fund right away, but use the rest for income drawdown.

Income drawdown allows you to leave your pension invested in the stock market, while at the same time giving you the flexibility to dip into your fund, when you need cash.

In other words, income drawdown is an alternative to buying an annuity, although there is a time limit. You are currently obliged to convert your pension pot into an annuity by the age of 75 (although this is a condition which a conservative government have said they would remove, if elected).

This gives you plenty of time to work with your pensions adviser, keeping an eye on stock market movements, and thus choose when the time is right to buy your annuity.

Be cautious with your income drawdown

It is essential, however, to be cautious with income drawdown, as when you draw upon it, you are taking money directly out of your pension pot, and depleting your fund.

A second advantage of income drawdown is that you remain the owner of your cash, so that it can be transferred to your family if you die, whereas with an annuity, your pension pot becomes the property of the insurance company and is theirs after your death. The advantage of the annuity, on the other hand, is its guarantee to you of a fixed income for life.