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Third Way Products

 

We suggest you read our Introduction to annuities before you read this section if you haven't already

Third Way Pensions (sometimes referred to as Guaranteed Retirement Options)

Against a background of increased volatility in stock markets, perceived poor rates being offered for Lifetime Annuities, concerns regarding future inflation and the fact that people are now living longer, the retirement market has been in need of a new type of product. These new plans are commonly known as ‘Third Way’ products and they are already very popular in the US and Japan. Essentially they fit in between a Lifetime Annuity and a Drawdown Pension plan as they offer the chance to still participate in stock market growth but with guarantees attached to either income, capital or both.

Whilst each specific product does differ in its features, the ‘Third Way’ pension is usually structured in one of two ways:-

Annuity – this option is commonly structured as a fixed term, value protected annuity plan, typically running for 5 years at a time, with the option to include guarantees to protect maturity values or the level of income. Unlike a traditional lifetime annuity, these products tend to offer the ability to alter income levels between certain limits and importantly, also allow the facility to provide a lump sum on death.

Drawdown Pension – the second type of Third Way plan is structured as a Drawdown Pension plan but with the option to apply a guarantee to the initial investment so that your fund value will never fall below what you originally paid into the plan. Some plans also allow all or a portion of any growth in the plan’s value to be locked in and a new minimum guaranteed level is then set. Finally, the option to select a guaranteed level of income is also commonly available.

Under both of the above options, you can choose to immediately take a tax-free cash lump sum and then, instead of buying an annuity, leave the remainder of the fund invested in a tax-efficient environment.

If the income is not guaranteed it may vary between set limits, and will be reviewed at some point between 1 year and 3 years depending on the product chosen. The range of income typically can be anything between nil and 100% of the income that could be paid by a single life annuity and will be based in the main on your fund size, age,  assumed investment returns and your expected longevity. The maximum limit is broadly equal to 100% of a single life annuity that you could have purchased at that point. Where a guaranteed level of income is chosen this tends to be a fixed amount although increases may be possible.

Please note that this type of contract can also be set up as a Phased/Drawdown Pension or Phased Retirement plan as mentioned previously,
If you die whilst in a Third Way product the death benefits can differ depending on how the particular plan you are using has been set up. You therefore need to check the specific product terms. In general however, they tend to fall into two scenarios:-

Under the annuity option - a return of the original purchase price less withdrawals and less a tax charge of 55%.

Under the Drawdown Pension option – a return of the fund value at that point less a 55% tax charge.

Alternatively, the spouse / dependent may also have the following options available to them:-

a) he or she can buy a lifetime annuity with the fund, or
b) he or she can choose to continue taking Drawdown Pension

Advantages

  • You are able to take all of your tax-free cash lump sum entitlement at outset.
  • Unless a guaranteed income is selected, you do not have to receive a set income but are able to vary it to suit your personal circumstances, up to a maximum limit, to supplement other sources of income.
  • You are able to mitigate your liability to personal income tax in certain years.
  • You have the potential to benefit from good investment performance in a tax-efficient environment and to exercise control over your own investment portfolio.
  • You are able to add a safeguard in the form of a guarantee to limit any drop in your fund value and some products allow gains to be locked in.

Disadvantages

  • High income withdrawals may not be sustainable during the deferral period
  • Taking withdrawals may erode the capital value of the fund, especially if investment returns are poor and a high level of income is being taken. This could result in a lower income when the annuity is eventually purchased and could also affect the long term financial security of your spouse/partner.
  • The investment returns may be less than those shown in the illustrations.
  • Annuity rates may be at a worse level when annuity purchase takes place. Although annuity rates generally increase with age, they have fallen dramatically during the past 15 years. This trend may continue.
  • A careful investment portfolio needs to be constructed which will involve some investment risk. If capital guarantees are not included then this means the fund value could fall which could affect your future income levels.
  • Withdrawing too much income in early years may have an adverse effect on preserving your pension purchasing power or preserving the capital value of your fund.
  • Increased flexibility and the addition of guarantees bring increased costs and the need to review arrangements on an on-going basis.
  • There is no guarantee that your future income will be as high as that offered by an annuity purchased today.
  • You may feel the prospect of the future higher income does not compensate for the known income available from an annuity now and for the rest of your life.
  • You may be prevented from withdrawing your chosen level of income due to the action of the GAD limits.
  • The Financial Conduct Authority (FCA) has particular concerns in relation to mortality risk. If you purchase an annuity, you may benefit from a cross subsidy from those annuitants that die relatively early. This cross subsidy is not present with Unsecured Income plans and so to provide a comparable income, a higher investment return will be required. The impact of mortality can be expressed as an annual percentage rate by which the net investment performance of the remaining personal pension fund would have to exceed the interest rate implicit in an annuity in order to break even. This effect has become known as the ‘mortality drag’.
  • If you opt for an annuity version of the Third Way plan the charges are typically built in to the annuity rates offered. If you decide to choose a Drawdown Pension version of a Third Way plan, the charges are added on top.
  • Both of these are generally more expensive than a traditional annuity or Drawdown pension plan.

You may find it useful to visit the FCA (Financial Conduct Authority) web site www.fca.org.uk and use the search facility there.

Both versions of this Third Way plan would generally suit a relatively sophisticated investor, who is capable of fully understanding the mechanics of the plan and the risks involved. The contract can be used as a useful tax planning tool and a means of accessing pension fund tax free cash without having to take the full taxable income and it importantly allows the individual to defer annuity purchase until their future plans are clearer. The availability of guarantees allows this type of contract to be suited to more cautious individuals who would not normally suit a Drawdown Pension plan however, the guarantees do come at a cost.

NEXT STEPS

Learn about the more complex options that you haven't read about yet:
Unsecured Pensions (also known as Income Drawdown), or
Phased Retirement or
Third Way options

or return to the start of the annuities guide.

Once you have understood as much as you need to about annuities, be sure to use our Retirement Finance Checklist in your run up to retirement.

However if you feel that you need some help from a financial advisor, then visit our section on obtaining financial advice, or our page on Laterlife selected services and associated advice.

 

 
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