Investment scams, poor value for money and a higher tax bill are all among dangers facing unwary sellers, warns Jeff Salway
Government plans to let retirees cash in their annuities will lead to “scandal” and people being “ripped off” despite regulatory efforts to protect consumers, industry experts have warned.
Proposed rules for the new secondary annuity market, which will allow pensioners to sell their income guarantees in exchange for cash lump sums, were set out by the City regulator last week.
But while the planned measures provide a clearer idea of how the market will work when it launches next April, the risks to those selling annuities were made stark by the Financial Conduct Authority (FCA).
In a consultation paper published on Thursday, it said that while secondary annuities may deliver flexibility for some people, “we believe consumers selling their annuity income could be exposed to significant risks”.
The changes will go ahead next year despite serious misgivings at the regulator and across the industry about the potential detriment facing people taking advantage of the new rules.
The secondary annuity market, proposed by the government in the March 2015 Budget, will allow existing annuity-holders to sell their policy to the highest bidder in exchange for a lump sum.
The aim is to extend the pension “freedoms” introduced last April to existing annuity-holders unable to take advantage of the greater flexibility.
But government figures showing that it expects the first two years of the secondary annuity market to generate a tax windfall of £960 million suggest the primary motivation may be to boost Treasury coffers. Some of that tax will come from people losing large chunks of their lump sum because the payments will be treated as normal income in the year they receive it. There will also be instances of the lump sum pushing the seller into a higher tax bracket.
Around 300,000 people will take up the option of cashing in their annuities, according to new HM Revenue & Customs figures.
That estimate may be very conservative, however. Research by Old Mutual Wealth suggests more than 850,000 people may want to cash in their annuity, typically so they can invest the money elsewhere or because they would prefer a lump sum to a regular payment.
“We expect to see a fire sale initially as customers rush to trade in their existing annuities because they feel they are getting poor value but had no alternative when they purchased them,” said Andy Bell, chief executive of investment platform AJ Bell.
But industry experts believe many sellers will be making a mistake. The regulator appears to agree and is “aware of the many risks potential sellers face”, said Rachel Vahey, an Edinburgh-based independent pensions consultant.
“To head these risks off at the pass, it is constructing layer after layer of convoluted protection in order to stop this market becoming a future scandal. However, their best efforts may not work,” she warned. “They can urge people to seek advice, compel some of them to do so, warn them of the risks. But ultimately, it’s the individual’s decision whether to sell or not – however poor value the deal may be.”
The FCA has set out several measures aimed at protecting those wanting to trade their annuity. They include clear risk warnings, a requirement to take advice where the annuity is valued above a certain thresholds and recourse to both the Financial Ombudsman Service and the Financial Services Compensation Scheme.
Firms will be required to recommend that sellers shop around and must also show them the “replacement cost” of their annuity income, as well as any offer from a buyer or broker. Brokers will have to provide “a clear and transparent fee” rather than receive commission from the buyer.
The Pension Wise service, established to support the rules introduced last year, will be extended to the secondary annuity market.
The need for advice is made clear by the significant and wide-ranging risks faced by annuity sellers.
The pitfalls highlighted by the FCA include the risk of running out of money in retirement because the guaranteed annuity income has been sold; poor value for money from the sale; the risk of investment scams and fraud; and the possibility that a lack of buyers in the market will make prices uncompetitive.
“It’s therefore hard to see how a sustainable, long-term secondary annuity market will function, given that we don’t know who the buyers will be or the composition of the sellers,” said Bell.
“Furthermore, we remain concerned that someone who has been ripped off once when buying an annuity could be ripped off again when they sell it.”
The regulator also pointed out that some people may come under pressure to sell their annuity in order to clear debts, while some sellers will lose entitlement to means-tested benefits.
It remains particularly unclear how someone holding an annuity on which they have already paid one set of charges can get good value from selling it. Sellers could lose 30 per cent or more of their potential income because of costs and upfront tax, Retirement Advantage has estimated.
“Most people thinking of trading their income for a lump sum will benefit from taking advice. This will be a complicated market, as the decision whether to trade or not will depend on whether the amount offered is a reasonable and fair reflection of the income being given up,” said Andrew Tully, pensions technical director at Retirement Advantage.
There is a small minority of people for whom selling their annuity will make sense, said Vahey. “Those with very small annuity incomes, which are largely irrelevant to their circumstances, may find a cash lump sum of more use. But if so, they have to go into the deal with their eyes open, aware that the lump sum offered almost certainly won’t represent the full value of the income given up.”