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ombudsman news

issue 60

March/April 2007

case studies - pension complaints involving alternatives to traditional annuities

At one time, people approaching retirement had to use their pension savings to buy a straightforward annuity that provided a guaranteed pension income. But for some years there have been a number of alternatives to the traditional annuity.

These include investment-linked annuities, temporary annuities, phased withdrawal, pension fund withdrawal (often known as "income drawdown") and, following last April's pension tax changes, unsecured income.

Disputes involving these alternative arrangements do not reach us in significant numbers, but we do see a fairly steady stream of them. This selection of recent cases illustrates the wide range of situations we see - and our general approach.

case studies

pension complaints involving alternatives to traditional annuities

issue 60 index of case studies

  • 60/1- life and critical illness insurance - back and neck problems - inadvertent non-disclosure
  • 60/2 - income protection insurance - non-disclosure after application had been made
  • 60/3 - life and critical illness insurance - asthma - inadvertent non-disclosure
  • 60/4 - life and critical illness insurance - smoking - monitoring of blood pressure - no non-disclosure
  • 60/5 - life assurance - alcoholic counselling - reckless non-disclosure

customer on limited income advised to take flexible annuity arrangement

Mr C consulted an independent financial adviser (IFA) for advice on how to make the most of his retirement income. He was in his early 60s and receiving incapacity benefit. This was due to be replaced by the state pension when he reached the age of 65. He had investments and savings of about £20,000 and pension plans worth around £52,000 in total. His wife had already retired and had a small state pension but no other income or savings.

The IFA recommended Mr C to put the money from his private pension plans into a five-year annuity and to invest the balance, with the aim of buying a further annuity at the end of the first five years.

Mr C went ahead and bought the initial annuity, which would provide him with just over £3,000 a year after he had taken a tax-free cash sum. The balance of his money was put into a mixed, unitised fund, classified as "medium risk".

After five years, this investment left Mr C with less money to put in the second annuity than predicted - with the result that his income fell. When the IFA rejected his complaint about this, Mr C came to us.

complaint upheld
Mr C told us that the IFA had never properly explained the risks involved in the recommended arrangement. After looking at all the evidence, we agreed.

The IFA had mentioned the possibility of buying a traditional annuity. And he had given Mr C an illustration of an annuity that would provide an income of £2,750 a year. However, the adviser had not explained the benefits of a traditional annuity. He appeared to have used the illustration purely to highlight the apparent advantages in the alternative arrangement.

We said that given Mr C's circumstances - in particular that the money involved represented all the income he and his wife had, apart from their state pension - the product was not suitable. Mr C could not afford to take a risk that his income might fall.

In our view, Mr C should have been advised to buy a traditional annuity. On the basis of the discussion that had taken place when he first consulted the IFA, we thought that if he had been properly advised, he would have taken an annuity that provided a level pension, with a 50% pension for his wife on his death.

Mr C had received more from the flexible annuity than he would have done from a traditional annuity. However, we did not think it fair that his future income should be reduced to reflect this. He had limited means, and had spent the "extra" income on ordinary living expenses.

We said that the IFA should compensate him by buying a traditional annuity for the future. The amount should be based on annuity rates available at the time of the advice. In this instance, we were able to refer to the rates in the illustration the IFA had shown Mr C when first advising him. Had this not been available, we would have provided the IFA with an appropriate historical annuity rate from a library of rates that we maintain.

customer advised to use pension fund withdrawal to repay a mortgage

Mr J, who was in his early 60s, contacted an adviser to discuss how best to fund his plans for retirement, which included buying a property from which he could run a bed-and-breakfast business.

He was a member of his employer's final salary pension scheme and had nearly £600,000 in a separate personal pension policy. He was also expecting to receive dividends of around £50,000 a year from a business in which he retained some shares.

The adviser recommended that Mr J should transfer the personal pension policy to a pension fund withdrawal arrangement. This would provide a tax-free cash sum that Mr J could use to pay the deposit on the property he wanted to buy. And by withdrawing a regular income from the arrangement, Mr J could meet the repayments on a ten-year variable-rate mortgage.

Mr J went ahead with this recommendation. He decided to take the maximum amount of income permitted under the tax rules. This meant that, net of tax, his monthly income was about 20% more than he needed for his mortgage payments.

As with all pension fund withdrawal arrangements, the limit on the amount of income that could be taken had to be reviewed every three years.

Because the fund had produced a lower-than-anticipated return, the first review resulted in a fall in the maximum amount available as monthly income. So Mr J was left with slightly less than he needed for his monthly mortgage repayments. Three years after that, the monthly income covered only around 85% of the amount he needed.

Mr J concluded that he would have to re-mortgage his property, over a longer term. He complained to the firm about its advice, saying it had never warned him of the risk that the recommended arrangement would not produce enough income to support his mortgage. When the firm rejected the complaint, Mr J came to us.

complaint upheld
Given his overall circumstances and his very particular income requirement, we did not think Mr J should have been advised to enter into an arrangement that put his income at risk. We established that he could, instead, have bought an annuity that would have ensured the mortgage payments were covered.

The amount of income he was able to withdraw from the arrangement had originally been greater than the amount he would have had from an annuity, even though it later dropped to a lower level. So it was possible that - overall - Mr J had received slightly more income than he would have had from an annuity.

We took this into account when looking at how best the firm could put matters right. We noted that;

  • Mr J's decision to take a high level of income was not a direct result of the unsuitable advice
  • the "excess" over the annuity income he would have received was not significant; and
  • he had other means.

We said the firm should compare the net income Mr J actually received - month by month - with the amount he would have received if he had taken an annuity. The differences - both positive and negative - should then be rolled up, with interest, to the settlement date. This calculation showed that Mr J had received less than he would have had from the annuity. So we said the firm should pay him the difference in the form of a lump sum.

We also said that the firm should add to Mr J's remaining pension fund, bringing it up to the amount he would now need to buy an annuity of the same size and in the same form as if he had taken it at the outset.

IFA tells customer that a pension fund withdrawal arrangement will not "erode" his capital - and defends its advice on the grounds that the customer was "annuity-averse"

Because arthritis was causing Mr B increasing difficulties, he decided to give up his professional practice and retire early. He was a self-employed architect with savings of about £40,000. His only pension plan of any significance was worth about £250,000. Mr B had a wife, who was nine years younger than he was, and four children, who had all now left home.

On the advice of an independent financial adviser (IFA), Mr B transferred £200,000 from his pension plan into a pension fund withdrawal arrangement.

Mr B later told us that the IFA had said: "If we can have £200,000 [as the initial investment], then income withdrawal will not erode your capital and you would have some growth ready for when you buy an annuity".

Mr B started drawing income from this arrangement, at a little below the maximum permitted level. However, the growth on the fund was not sufficient to cover the amount of income he was taking. When it became clear that he would not be able to continue taking an income at the same level, Mr B complained about the advice he had been given.

complaint upheld
Mr B told us he had clearly specified that he had not wanted to take any risks. He said the adviser had stressed the advantages of the recommended arrangement. In particular, the adviser had said that Mr B's capital would "not be eroded", so he would eventually be able to pass on his money to his children. Mr B said this had seemed an attractive prospect - but it had not been a special concern of his when he consulted the adviser - and had not been a deciding factor.

The IFA defended its advice, telling us that Mr B had been "averse" to buying an annuity because he had been particularly keen to be able to pass funds down, in due course, to his children.

We looked at all the evidence, including the IFA's misleading statement that the proposed arrangement would ensure Mr B's capital was not "eroded". We concluded that Mr B had not been informed of the risks. In view of the rosy picture the IFA had painted of the pension fund withdrawal arrangement, it would not be surprising if Mr B had appeared to be "averse" to an annuity. That did not mean he would not have bought an annuity, if the risks of the alternative arrangement had been explained to him.

We thought that if he had been appropriately advised, Mr B would probably have bought a traditional annuity, giving him a pension and a two-thirds pension for his wife, after his death.

So we said the IFA should calculate the net monthly amount Mr B would have received - to date - from such an annuity. It should compare that with the amount he got from the recommended arrangement. And it should add interest, on a monthly basis.

If the calculation showed that Mr B had received less than he would have had from a traditional annuity, then the IFA should pay Mr B the difference. We said the IFA should also pay the difference between the realisable value of the fund and the amount it would cost him to buy an annuity for the future.

If Mr B had received more income than he would have done with a traditional annuity, then the firm could reduce the compensation accordingly.

customer needing to withdraw income within a year or so is advised to put pension funds into unsuitable investments

Ms K, a senior manager in her late 50s, had started giving serious thought to her retirement options. She worked full-time, but with her employer's agreement she occasionally did paid consultancy work for other companies.

She didn't feel she was yet ready to retire altogether from her job. However, semi-retirement within the next twelve months or so seemed an attractive prospect, particularly as she thought her consultancy work was likely to continue for some years.

Ms K sought financial advice from XY & Co, the IFA that advised her employer on its money purchase pension scheme. Ms K had built up a fund of about £450,000 in this scheme, invested in an equity broker fund operated by XY & Co. She also had other investments, totalling around £200,000.

XY & Co's representative advised Ms K to transfer the money she had built up in her employer's pension scheme into a personal pension, invested in the same equity broker fund. The representative told her that doing this would enable her to start withdrawing an income as soon as she needed to do so.

Ms K acted on this advice, but was alarmed to find that the fund fell significantly in value over the following year. She had not yet started to withdraw an income, but was planning to do so very shortly. After consulting different advisers, Ms K changed the pension investments into cash, gilts and a modest amount of equities.

Ms K complained - first direct to XY & Co and then to us - that the fund into which it had transferred her pension funds had been inappropriate because it was too risky.

complaint upheld
We found that XY & Co had not given Ms K any proper advice before transferring her funds out of her employer's scheme. The firm said it had not needed to do this because there had been no real change; Ms K's pension remained invested in the same fund throughout.

We pointed out that the decision to invest the employer's scheme in the broker fund had been made by the scheme's trustees, not by Ms K. So XY & Co should have given careful consideration to Ms K's personal circumstances. They should then have made a suitable recommendation based on those circumstances.

We did not consider it suitable to have advised her to leave the entire fund in equities. Part of the fund, at least, should have been protected from stock market volatility.

It was impossible to say exactly what the most appropriate recommendation would have been in this case - there were a number of possibilities. But we decided that fair compensation should be based on the assumption that a quarter of the fund (representing a possible tax-free cash sum) should have been invested in cash and another quarter in a gilt index fund.

So we said the firm should calculate what Ms K's fund (invested in such a way) would have been worth, on the date on which she acted on her new adviser's recommendation. It should then pay her the difference, plus interest.

income withdrawal a suitable option in situation where there was an urgent need for income

Mr E was in his mid-50s when his job was made redundant. He had an urgent need for income and was very worried about his future. Even though he had started to train as a financial adviser, his future earnings would be heavily dependent on commission.

Mr E had very little in the way of savings, but he did have around £25,000 in a pension policy that carried guaranteed annuity rates. He contacted the pension provider for advice and was told he should start withdrawing an income from his pension fund.

The provider's representative said that, initially, Mr E would need to withdraw the maximum amount of income permitted under the policy. However, Mr E would be able to reduce the level of his regular income from the policy once he became established in his new career and his commission earnings began to build up.

Mr E lost the option of taking up the annuity rate guarantee, because this would only have been available if he bought an annuity when he was 65. Mr E later said that the representative had not explained this. Some years later, Mr E complained. The fund had suffered some losses, and he was approaching the age at which he would have been able to take advantage of the annuity guarantees. He said he had not understood the risks involved and had not realised he would lose the guarantee.

complaint rejected
We concluded that Mr E would have had a fair understanding of the risk he was taking. Although he had been only a trainee adviser at the time of the advice, risk would have been explained at an early stage in his training. In any event, it was evident from the paperwork we saw that the representative had provided a clear explanation.

Mr E's urgent income needs had driven his decision and we considered that, in view of the limited options available to him, he had received suitable advice.

The representative should have explained to Mr E that by taking the recommended course of action, he would lose the annuity rate guarantee. However, we did not think the representative's failure to do this had made any difference to the outcome. At the time of the advice, annuity rates were significantly higher than the guaranteed rates. But in any event, it would not have been possible for Mr E to obtain the income he needed without losing the guarantee.

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ombudsman news issue 60 [PDF format]

ombudsman news gives general information on the position at the date of publication. It is not a definitive statement of the law, our approach or our procedure.

The illustrative case studies are based broadly on real-life cases, but are not precedents. Individual cases are decided on their own facts.