Regulatory guidanceMember retirement options

If an occupational scheme provides benefits on a defined contribution (DC) basis, trustees must ensure that there is an efficient process in place to convert the member's money purchase fund into a retirement income.

This is sometimes referred to as the 'decumulation process'.

The regulator's research has identified that there is little information generally available for employers and trustees on the practical and operational issues they face in relation to this process.

The aim of this guidance is to encourage trustees and employers to:

• think carefully about the retirement options offered by their scheme and to follow good practice that is likely to lead to informed decisions being made; and
• recognise and emphasise to members (and dependants) the advantages of obtaining financial advice from an appropriately authorised adviser.

Indications are that shopping around for an annuity can often produce a significantly better benefit. In general, the decision to purchase an annuity is irreversible. It is important, therefore, that an informed choice is made.

Open market option

As an alternative to the scheme's process, the member (or dependant) has a right to take the proceeds of the fund to buy an annuity at a current market rate from an insurance company of their choice (the 'open market option').

Different schemes will offer different levels of support to members (or dependants) in choosing their benefits, whether or not the open market option is chosen.

Our Trustee toolkit includes information on the open market option in a section specifically relevant to DC schemes.

Good practice guidance

The Pensions Regulator is committed to providing good practice guidance that will result in improvements to the running of schemes with a DC element.

We recognise that there are many well-run schemes and our approach is to share examples of good practice that trustees and employers can draw upon and, where appropriate, to signpost existing guidance and tools to avoid overlap or information overload.

We've developed this guidance with industry and other government bodies. It's linked to existing information, such as the scope guidance for the regulator's Trustee toolkit, and it complements initiatives being taken by other bodies in relation to the decumulation process. This includes work being carried out as a result of the Review of the Open Market Option (OMO) led by the Treasury and the Department for Work and Pensions (DWP) in 2007, in which the regulator participated.

Throughout this guidance we refer to members (or dependants) to mean those people who are shortly going to benefit from a pension scheme. These include members, deferred members and the spouses or partners of members who have died before receiving their pensions.

This guidance does not focus on communications with members in the period leading up to retirement – we'll be producing guidance on this in due course.  Members with a good level of financial awareness will plan for their retirement well before they come to consider annuity options.

This guidance does not propose any new requirements over and above those that already exist.

Useful websites

Trustees may wish to consider making these online resources available to scheme members who are approaching retirement:

• www.fsa.gov.uk/tables
  FSA Comparative Tables on pension annuities
• www.moneymadeclear.fsa.gov.uk/
  FSA Money made clear guides
• www.thepensionservice.gov.uk/
  information about pensions and pensioner benefits
• www.pensionsadvisoryservice.org.uk/
  The Pensions Advisory Service (TPAS) has developed an online annuity planner for members to provide them with information on annuities
• www.unbiased.co.uk/
  Help in finding an IFA

And for those interested in a more detailed analysis of the relevant issues, we've put together a list of sources (Annex C).

There are a number of methods of providing an income in an occupational DC scheme. These are illustrated in Figure 1.

Figure 1: Diagram to illustrate the main ways of providing retirement income from an occupational DC scheme

This guidance focuses on the channels in Figure 1 which relate to the open market option and the lifetime annuity. You'll find more information about the different ways of providing a retirement income from an occupational DC scheme in the DC module tutorials of the Trustee toolkit

The Financial Services Authority (FSA) has rules around the provision of information to members of personal pension schemes, including SIPPS, stakeholder pension schemes and freestanding additional contribution schemes.

Before any benefit can start to be paid, the member (or dependant) must be given the opportunity to ask the trustees of the scheme to use the fund to buy an annuity of his or her choice from an insurance company.

There could be serious tax consequences for the member (or dependant) if this does not happen. If this option (referred to as the 'open market option') is taken, in practice the member (or dependant) will need to choose the form of the annuity as well as the insurance company who will pay it.

It is a legal requirement (Annex A) to offer an open market option.
 
Main methods of providing a retirement income are as follows:

Lifetime annuity

This is the method currently used by most DC schemes. An annuity is purchased from an insurance company to provide an income for the rest of the member's (or dependant's) life.

Typically schemes will suggest an annuity and tell the member (or dependant) about it at the same time they are told about the open market option – they can then 'shop around' and choose a different annuity (ie exercise the open market option) or agree to have the annuity suggested by the trustees.

Scheme pension

This is not a common method of providing an income, principally because of the risks involved.

A pension is paid by the trustees direct from the scheme. An actuary calculates how much pension could be provided directly from the scheme using the member's money purchase fund and a scheme annuity rate chosen by the trustees.

There is a risk that the member (or dependant) outlives the scheme retirement savings, ie the pension has to be paid for longer than the trustees anticipated when the annuity rate was determined.

Unsecured pension or 'income drawdown'

As this can be difficult to administer few DC schemes offer this facility.

Essentially, income payments are drawn from the fund, within limits set by HM Revenue and Customs (HMRC), while the fund continues to be invested with the objective of achieving investment growth.

Alternatively secured pension 

This is available only once a member reaches age 75 – it's income drawdown with some special rules.

As most members will retire and take their retirement income before they reach age 75, it's not an option that is commonly used.

Practices relating to the open market option will vary between DC schemes. What is right for one scheme may not be right for another. Trustees should consider what approach is most suitable, bearing in mind the needs of their members (or dependants) and the circumstances of the scheme.

For example, factors influencing the decision may include:

• the numbers of members reaching retirement;
• their individual fund values;
• membership profiles;
• how expenses are met (for example are they paid by the employer?);
• the scheme's advisers, who may provide access to a range of services;
• the timing and process for the payment of benefits from other schemes of the employer;
• whether or not the scheme is or has been contracted out on a protected rights basis.

In considering what practice to follow, trustees will need to consider a number of key points.

Process

Schemes should have an appropriate process in place to convert money purchase funds into an income.

Our research shows that many DC schemes have not had large numbers of members (or dependants) draw their benefits and do not yet have an established process for this critical stage in the individual's retirement planning process.

Other schemes that have been established for longer may benefit from a review of existing processes. Failures in the process can lead to delays and potentially could result in a reduction in the benefits provided by the member's money purchase fund and increase the likelihood of complaints or disputes.

Therefore, the process:

• needs to be set out clearly and understood by the parties involved;
• should take account of the situations of different recipients of pensions, for example those retiring early, spouses and dependants of deceased members, deferred members as well as actives;
• should have regard to practical matters such as the need for members to have information at an early stage to enable them to exercise the open market option, and the guarantee period on annuity quotations; and
• needs to provide for there to be close liaison between the different parties at key stages, so that the process operates smoothly and quickly without breakdowns in communication.

Good practice recommendation:

• Trustees need to ensure that the retirement process meets the needs of the scheme and its members and that it is clearly set out and understood by the parties involved.

View guidance on Process

Governance

Trustees have certain duties and obligations to ensure the good governance of the scheme.

In particular:

• they must comply with legal requirements, in particular by offering the open market option and providing the required information;
• they need to understand their responsibilities in relation to the conversion of the member's money purchase account into a retirement income or an income for a dependant
• entitlements of members (or dependants) will be set out in scheme rules and the rules must be followed; and
• if necessary, trustees may wish to consider amending the rules to set out how they wish to operate the open market option

Good practice recommendations:

• Trustees must observe legal requirements and follow scheme rules; if appropriate, scheme rules may be amended to reflect the process that trustees propose to follow.
• Trustees need to have a good understanding of the requirements of good governance; they should have an appreciation of the process and the issues that can arise so that they can question their advisers and decide what approach is best for their scheme.

View guidance on Governance 

Support for the member

The process for converting money purchase funds into an income normally requires the member (or dependant) to take a decision.

If they do not get the right information or they do not understand the decision they need to take, they may receive an inappropriate annuity or it may simply be poor value for money.

Figures provided by the FSA suggest that some people may be able to improve their annuity by as much as 30% by shopping around. The difference can be even greater when the member qualifies for an impaired life annuity.

In general, the decision to purchase an annuity is irreversible. It's therefore important to consider:

• do members (or dependants) receive advice free of charge or only if they engage someone to advise them at their own expense?
• are communications clear so that the member (or dependant) understands what they need to do?
• do they have the right information so that they can take informed decisions?
• are they referred to sources of help and support?

Good practice recommendation:

• Trustees should consider what steps they can take to support members (or dependants).
• Trustees should emphasise the benefits of obtaining financial advice from an appropriately authorised adviser where members (or dependants) are asked to make a financial choice.
• Trustees should facilitate a level of support to members (or dependants) that will enable them to make properly informed decisions on their retirement and annuity options.

View guidance on Support for the member 

Keeping abreast of developments

Trustees need to maintain an understanding of current good practice.

There is currently much innovation in the area of DC retirement provision so approaches may need to be changed from time to time to take advantage of these.

Good practice recommendation:

• Trustees should be aware of what is available in the market so that they are in a position to take advantage of new opportunities, where these are appropriate to their scheme.

Monitoring the outcome

In order to ensure that they are following current good practice, trustees will need to monitor the operation of the retirement process, considering:

• do trustees take steps to find out whether the process lived up to the reasonable expectations of the member (or dependant)?
• how many members (or dependants) exercise the open market option; if they do not, do they consider their alternatives before accepting what is on offer?
• how frequently are processes reviewed to see whether any improvements could be made?

Good practice recommendation:

• Trustees should monitor the operation of the retirement provisions in their DC scheme so that they identify the opportunity to introduce improvements when possible.

The following pages contain guidance for trustees in each of the areas of process, governance and support for the member (or dependant).

The responsibility sits with the trustees to ensure their DC scheme or arrangement has processes in place that ensure:

• the member (or dependant) is told about their options (including the availability of the open market option); and
• the member's fund can be converted into an income.

The regulator's research suggests that although schemes may have different practices in relation to aspects of the decumulation process, the overall end-to-end process will be broadly similar for all schemes.

The end-to-end process a trust-based DC scheme will usually follow in order to secure its scheme pensions or annuities is illustrated below in Figure 2.

Where a DC scheme is insured the trustees will no doubt want to ensure that the insurance company's procedures will fit in with scheme practices and processes.

Figure 2: Diagram to show a good practice timeline for the retirement process

You might want to take a look at a more detailed description of the process (Annex B).

Trustees should be familiar with their scheme rules and should know and understand the scheme provisions dealing with the payment of pensions.

The open market option allows the individual to have choice over the annuity provider.

Scheme rules may define some aspects of the process such as:

• how benefits are to be secured if the open market option is not used (eg by purchase of an annuity or annuities);
• allowing the member (or dependant) to make choices (eg to take part of their benefit as a retirement cash sum, to have an annuity that increases year by year and/or (in the case of a member) to have an annuity that continues to a spouse or dependant after their death;
• how the benefit will be secured if the member (or dependant) does not respond to communications;
• the fact that the open market option is available and what steps the member (or dependant) needs to take in order to exercise it, including any time limits that apply; and
• provisions relating to the cost of advice to the member (or dependant) (eg if the trustees incur costs, the rules may give them the power to recover those costs from the member's fund).

The level of help given to members (or dependants) might be categorised as 'default', 'limited choice' and 'assisted choice'.

These broad strategies are defined below.

Assisted choice
Scheme facilitates independent financial advice for members

Limited choice
Trustees appoint an annuity broker to search the market and find a competitive quote on a basis chosen by the member

Default
Trustees appoint an annuity broker to search the market and find a competitive quote on a basis determined by the trustees

We've set out in a table (Annex C) the common features of these approaches and the factors that might influence the trustees and the employer in their choice of a particular approach.

Members who obtain advice from a suitably authorised adviser are more likely to choose the form of retirement income or annuity that is appropriate to their situation, particularly where alternative options are available to them in the marketplace.

The procedure for setting up a pension may not always be straightforward.

Trustees will need to think about:

• what steps to take if members (or dependants) do not respond to communications;
• how to deal with small funds;
• when to disinvest the fund; and
• what special considerations, if any, apply to pension credit members (with benefits arising from a pension sharing order).

In most cases the scheme's advisers will be able to discuss the options for dealing with situations that can occur.

You might want to take a look at a more detailed description of the process (Annex B).

Legal requirement to offer an open market option and notify individuals of its availability

The Figure 3 illustrates the legal requirements.

 

Figure 3: Legal requirements

The law relating to the disclosure of information requires trustees to tell members and dependants about the availability of the open market option.

Tax legislation requires trustees of registered schemes to give members and dependants the opportunity to exercise it.

In particular:

• Under the tax legislation, before any scheme pension or annuity can start to be paid from a registered scheme:
  • Pension rule 4 in Section 165 & Schedule 28 of the Finance Act 2004 requires that a member is given the opportunity to exercise the open market option;
  • Pension death benefit rule 5 in Section 167 & Schedule 28 of the Finance Act 2004 requires that the dependant of a member is given the opportunity to exercise the open market option.
• Under the Occupational Pension Schemes (Disclosure of Information) Regulations 1996 (SI1996/1655), trustees are required:
  • under Regulation 5(6) & Schedule 2, to tell a member about the availability of the open market option at least six months before the member's normal pension age or the other date the member has agreed with the trustees for the start of his scheme retirement income (and where that is not possible because the other date is less than six months away, then the information has to be given within seven days of the date the agreement was reached);
  • under Regulation 5(8) & Schedule 2, to tell the dependant of a member about the availability of the open market option as soon as they can after learning of the death of a member but no more than two months after learning of the death.

Description of the retirement process

The trustees have responsibility for the process. Although activities may be delegated to an administrator, it will still be for the trustees to see that it operates as it should.

1. Stage 1. This is the start of the process of setting up a scheme pension or annuity; typically a scheme member will be a few months away from his scheme normal retirement date when the process begins.
2. The process should include a scheme reminder system; in some cases the trustees may also get a reminder from the scheme advisers or the administrator. The trustees should also receive information from the employer, especially in cases where there have been talks between the employee and the employer about arrangements for:
   • early retirement (by agreement, on ill-health grounds or because of redundancy); or
   • late retirement (after normal retirement date).
   Trustees should ensure that scheme records are checked regularly to identify all members who are due to retire from service in the next 12 months and all deferred members whose benefits are due to commence in the next 12 months.
3. The trustees also need to comply with the requirements of the Occupational Pensions Schemes (Disclosure of Information) Regulations 1996 (SI1996/1655) (Annex A). The information that needs to be given is detailed in paragraph 7 of Schedule 2 to the Regulations. Briefly, it is:
   • A statement that the member is able to select an annuity.
   • A statement that the member is able to select the annuity provider (where that applies under the scheme rules).
   • A statement that different annuities have different features and different rates of payment and to give some examples of the different types of annuity that are available, including:
     • Level annuities and increasing annuities
     • Single life and joint life annuities
     • Annuities with or without guarantee periods

     This requirement can be satisfied by issuing the regulator's guidance on 'Your Retirement Choices'

   • A statement that the member should consider taking advice about the most suitable annuities. This last requirement may already have been met by information given to the member in the scheme booklet or other member communications.
4. Apart from giving information to the member at this stage, it will also be necessary to check with the member that the records containing the member's details are accurate.
5. The trustees or administrator should also consider the size of the member's fund. In some cases, for instance where the member's fund is very small, the size of the fund might limit the options open to the member. For example, escalating annuities and annuities for spouses might not be available. If the member's fund is very small the open market option might not effectively be available at all, as insurers have minimum premiums.
6. There may be an option to commute part of the member's fund for cash, and (if the fund is large enough) there may be the possibility of setting up dependants' pensions from the same fund.
7. Stage 2. Obtaining an annuity quotation. Most DC schemes secure their liability to provide pensions by the purchase of an annuity from an insurance company.
8. Often the scheme may have a close business relationship with a number of insurers, or with an adviser who may obtain the quotations. Unless the scheme rules already tell the trustees what type of annuity they should provide (as the scheme default) the trustees will also have to make some decisions about the type of annuity the scheme is going to offer, for example:
   • will it be a single life pension or should it have contingent pension rights attached to it?
   • will it have post retirement increases or will it be a level (ie non-increasing) annuity?
   • will it be assumed that the member will take the maximum tax free cash lump sum at retirement (so a smaller amount will be available to purchase the annuity)?
9. If quotations are obtained on different bases, the trustees will ensure the member is able to see how the different factors can affect the amount of pension.
10. Stage 3. Once the trustees have received quotations from the insurance companies the next step is to:
    • pass the quotation on to the member; and
    • remind the member about the availability of the open market option.
11. What the trustees say to the member about the open market option can influence whether or not the member exercises it. So the trustees will need to consider the messages communicated to the member when the annuity quotations are sent. Messages that trustees might consider will include the kind of practical information mentioned earlier as well as ensuring the information requirements of the disclosure of information regulations are met. The trustees should also:
    • make clear to the member the extent to which they are willing and able to engage in a dialogue and possibly consider offering face to face meetings;
    • tell the member if the employer is willing to meet the cost of providing independent financial advice for the member or, alternatively, what will happen if the member asks for quotations on different bases;
    • give timescales for the member to reply and explain that annuity rates are only guaranteed for the period stated on the quotations;
    • ask the member to consider taking independent financial advice, particularly if he has a substantial fund or if he has other sources of pension; and
    • tell the member what happens if the member does not reply.
12. Stage 4. Here the member has the opportunity to consider exercising the open market option. To do this, the member needs to:
    • search the annuity market to find the annuity that is most suitable (the may do this with the help of an independent financial adviser or by referring to the Financial Services Authority's comparative tables);
    • get in touch with the insurance company (again, the member may have an independent financial adviser to help); and
    • contact the trustees to let them know the chosen annuity provider.
13. The trustees then need to liaise with the member, the insurance company, and the member's independent financial adviser (if he has one) to ensure the appropriate forms/documentation are completed and signed to allow the annuity purchase to go ahead.
14. Some examples of the kinds of documentation that might be required by the insurance company are given in the ABI guidelines.
15. The trustees may try to maintain regular contact with the member over this period, reminding the member to consider speaking to an independent financial adviser and re-stating the deadline by which the trustees need to know the member's intentions.
16. Where the member has decided to exercise the open market option then usually there might be a final check carried out, to ensure there is no change to the price of the annuity. It may be necessary to obtain further quotations and make comparisons if guarantee periods have expired.
17. Once the member has told the trustees about the exercise of the open market option or confirms on what basis he wants to proceed, (if the member fails to do that, then the trustees may proceed on the expiry of the deadline they have set) the trustees or the scheme administrator can put in motion the administrative steps they need to take to start payment of the member's pension or annuity. The decision to purchase an annuity must be taken by the trustees.
18. Next steps will include disinvesting the member's fund on or close to the day of the member's retirement in order to generate the purchase price of the annuity, or instruct the adviser or the insurance company to do so. The member should be informed of the date by which this will happen. It may be necessary to obtain further quotations and make comparisons if guarantee periods have expired.
19. Stage 5. In most cases the pension will be paid by the insurance company from which the annuity has been purchased.
20. Typically where the member has exercised the open market option the annuity will be purchased in the name of the member, a contract will then exist between the individual and the insurance company and the trustees will be discharged from any liability to provide further benefits.
21. If, exceptionally, the annuity is written in the name of the scheme trustees the contract is made between the insurance company and the trustees, the individual remains a member of the scheme. The trustees may enter into an arrangement with the insurance company under which the insurance company pays the pension direct to the member as agent for the trustees.

The flowchart overview illustrates the stages in this process.

Table illustrating features of 'Assisted choice', 'Limited choice' and 'Default' approaches to the provision of annuities

Type of strategy for helping members with open market option

	Assisted choice (trustees direct member  to advisory firm)	Limited choice (trustees search the annuity market and make  recommendation)	Default (no help for member  from trustees)
Features of strategy	scheme facilitates independent financial advice for members employer may bear the cost trustees purchase annuity selected by member under open market option if member does not exercise open market option then annuity is chosen by trustees	trustees appoint an annuity broker to search market for a competitive quote on a basis chosen by member (eg joint life, escalating with guarantee) trustees may provide assistance (eg meetings) to supplement information required by disclosure member may take OMO if preferred	trustees appoint an annuity broker to search market on a basis determined by the trustees (eg joint life, if married, escalating with guarantee) member may take OMO if preferred (Example of this strategy used in the DC module of the regulator's trustee toolkit
Availability of one to one assistance or advice	member is directed to the annuity advisory firm with whom the trustees have a relationship which will offer help to the member to exercise the open market option member can go to a different IFA or obtain his own annuity quotes	member is encouraged to obtain independent annuity advice at own expense member can go to IFA or obtain his own annuity quotes	no assistance is offered to the member with the exercise of the open market option member can go to IFA or obtain his own annuity quotes
Advantages for member	should always lead to an informed decision and ensure benefit is suitable no cost to member for advice	if IFA is consulted it leads to an informed decision and ensures benefit is suitable annuity basis is that chosen by member	if IFA is consulted it leads to an informed decision and ensures benefit is suitable
Rules of scheme typically cover	annuity will be provided in the form the member chooses in the absence of member choice a default annuity that applies time limits within which member has to act cost/expenses of advice if contracted out, how protected rights are dealt with	annuity will be provided in the form the member chooses in the absence of member choice a default annuity that applies time limits within which member has to act if contracted out, how protected rights are dealt with	type of annuity will be provided according to basic information about the member time limits within which member has to act if contracted out, how protected rights are dealt with

List of sources

Those interested in a more detailed analysis of the issues in relation to providing member retirement options may find this list of sources useful.

• The Annuities market, December 2006, HM Treasury
• Annuities & accessibility, March 2006, Cass Business School
• Pension maturities Statement of Good Practice, 2006, ABI
• Various retirement planning guides, The Pensions Service (DWP)
• Money Made Clear Guides, FSA
• Just the facts about getting financial advice, January 2008, FSA
• Survey of Annuity Pricing, 2006, CMPO Bristol University
• The Trustee toolkit, the Pensions Regulator
• Various consumer guidance, TPAS  
• How the Pensions Regulator will regulate defined contribution schemes in relation to the risks to members – consultation report, April 2007, the Pensions Regulator
• A guide to personal finance, The Financial Fringe (a collaborative work between eight trade bodies)
• DC update, January 2008, the Pensions Regulator
• FSA comparative tables on pension annuities
• For help in finding a financial adviser