An equity release product could make up for a low pension annuity at retirement. If used wisely, equity release schemes could be the key to a fruitful retirement. As the UK elderly live longer, disappointing pension annuities are becoming a real issue, which could explain a recent uptake in the number of equity release schemes taken out.

Until recently, property had experienced a boom, meaning that many homeowners of pension age are rich in property. Equally, though, they may have no actual cash to spend. This is where equity release comes in, allowing home owners to take out a loan against a property in order to fund retirement.

There are two main types of equity release scheme. Their is the equity release lifetime mortgage that allows a homeowner to take out a loan secured against the property. The lifetime mortgage is popular because it means you continue to own your home and you can repay the loan with the proceeds of the sale of your home after death, or if you move out into a care home.

There are two types of lifetime mortgages to consider, including an interest only mortgage where you get the loan as a lump sum and pay interest on the loan each month at a fixed or variable rate. Then there is the more popular deferred interest mortgage, where rather than making repayments, interest is rolled up during the mortgage with both capital and accrued interest being repaid when your home is sold.

With both types of scheme, you can choose how to spend the newly acquired capital. A home income plan, for example, will use the mortgage capital to buy an annuity, which consequently gives you a regular income that is normally fixed for life. Again, you can choose whether to make interest payments or have these deferred.

There is the less popular home reversion plan where you sell part or your entire home to a reversion company or individual. However, this would mean that you no longer own your home but can continue to live there as a tenant of the reversion company or individual. 

According to SHIP (Safe home income plans), the body that represents more than 90 per cent of the UK’s equity release business, the sector saw a 14 per cent increase in volumes for the first quarter of 2008. Hardly surprising, given the current financial climate. Pensioners are finding it tough and releasing equity from property may be the only way to survive through retirement for some.

Because equity release schemes are normally only available to those over 55, they could offer the perfect way to fill the gap between a low pension annuity and a previous salary. 

Some say falling house prices are crashing through retirement plans, and having a great impact on retirement incomes, especially if the pension annuity is too low. The case of an elderly couple wanting to trade down is typical of the problems people are facing at the moment. Consider this property and scenario:

The four bedrooms, stone fireplaces, staircase and huge mature garden would make a beautiful Georgian property a wonderful family home – for someone with the cash to renovate it. But the elderly owners now find it too large and expensive to run. They want to trade down and are probably hoping to put some cash in the bank. But the situation is dire because of current market conditions.

The house went on the market at over £900,000 a year ago but didn’t find a buyer. The couple have now changed agents and it is on the market for informal tenders above £550,000. An obvious buyer would be a builder who could carry out the undoubtedly expensive renovation and sell it on, not a family buyer. However, the house is large and expensive to heat.

More and more we are seeing similar cases in which people are depending on property for their retirement income. Where the value of their property has fallen there is often very little they can do except sit it out. Many older people will have owned their homes for 20 years or more, so a good profits are likely. High heating costs are likely to affect the price of otherwise very desirable large family homes, the sort that many people coming up to retirement want to sell. 

It is true to say that relying on property to fund retirement is a risky strategy. There is no real alternative to a pension pot and a pension annuity. If you are expecting to trade down there often isn’t much left after you have bought a new property and if you are tied into selling at retirement or a specific time, you can get caught out by the market.

The problem is that it is difficult to persuade people that they need diversified investments if they are not to be caught out by a downturn just as they want to retire. Some are having to defer retirement.

The message remains the same – and it has not changed because of the downturn in house prices – you need an appropriate spread of assets across all sectors.

Very often, the financial responsibility of looking after elderly relatives falls to their children or grandchildren. Indeed, I have heard comments on the radio today about the costs of home care for the elderly. According to Engage Mutual in a recent report, more than half of retirees struggle with their finances.

Nearly a third of British adults have at least one parent over the age of 65. It therefore should come as no surprise that more than one in ten fear they cannot afford to support their parents. Longevity really is becoming a problem these days. In the past, however, families did often just ‘get on with it’.

Mr. T, from Basingstoke, has enduring power of attorney for his grandmother. She has been in residential care since February 2005 due to loss of mobility. They are worried because she’s happy in the home she is in and they didn’t want to move her because they couldn’t afford it. After the sale of her house, the money would have dwindled away fast. They needed to make the money work for them.

The grandmother has a retirement income of just below £10,000 a year; her care fees amount to £33,000 a year. The sale of her property fetched £124,000 and Mr. T spent £88,000 of it on buying a care fee annuity for £24,000 a year. The amount increases every year in line with the Retail Prices Index (RPI) plus an additional two per cent. Unfortunately, when his grandmother dies some of the money spent will never be recovered.

Like a retirement annuity, the money dies with you unless you pay extra to protect it. Mr. T did arrange 50 per cent capital protection, meaning that his family will get a sum of money minus care home fees in the event of early death. The annuity is almost future-proof. They have spent a lot of money up front but it’s worth it and they have complete peace of mind because the money is more or less running itself.

Interestingly, more than three quarters of enquiries fielded by Saga last year were from people acting as power of attorney for a parent.

Few people realise the full cost of retirement until they become responsible for an elderly relative. Residential homes, for example, cost on average £20,800 a year; nursing homes cost about £30,000.

The governor of the Bank of England, Mervyn King, is urging us to make the best of the hard times coming. He has inflation could rise sharply in the second half of this year, to above 4%. He also expects inflation to stay “markedly” above the 2% target the government want until “well into 2009″.

In his recent annual speech to City luminaries at the Mansion House, he was pointedly downbeat. He said: “Rising fuel, gas, electricity and food prices mean that average real take-home pay will stagnate this year. It will not be an easy time, and I know that some families will find it particularly difficult.”

Mervyn King also emphasised that the Monetary Policy Committee (MPC) would be prepared to take “whatever action is needed” to keep inflation under control, which does give a strong hint that interest rate cuts are off the agenda. It could be said that consumers might be well advised to brace themselves for a rate rise

However, Alastair Darling, the chancellor, was more upbeat. In his first speech to the annual dinner, he was at pains to point out that the current rate of inflation at 3.3% “remains low” compared to the 1970s.

The chancellor is right: inflation is low compared with the 1970s. But that doesn’t help families from the pain of rising prices. Inflation is running at an 11-year high, double the government’s official 2% target. Inflation is running even higher if you look at the Retail Prices Index (RPI), which includes the cost of housing. 

If you are about to retire inflation could be a really bad thing, because pensioners tend to lock into a pension annuity that pays a fixed income. You could buy an index-linked annuity, which pays less in the early years than a level annuity but rises in line with inflation, usually RPI. In theory, an inflation-linked annuity is a good idea. But not in practice.

It’s a tough choice for people who are about to retire. If they take out a level annuity, they are making some strong assumptions about their ability to cope with inflation in the future. It could be that an escalating annuity, which rises each year by a fixed amount, say 3%, could be a good choice. You are then buying at least some protection against inflation in your retirement.

There are many powerful people saying that the House of Lords must act to prevent pension savers being short-changed. The Pensions Bill should be re-considered and amended to ensure that millions of people in workplace pensions are able to benefit from contributions based on their full salary. If things aren’t improved then people will suffer with lower retirement incomes and pension annuities. 

The ABI, NAPF, ICAEW and SPC[1] have produced a comprehensive briefing document for members of the Lords, ahead of the Bill’s Committee Stage in the Lords. Amendments, which we hope Their Lordships will support, will be tabled and discussed during the debate. 

For pension reform to succeed, we need to see more savers, and they need to be saving more for their retirement. Workplace pensions already serve millions of people very well, and the extension of automatic enrolment to these schemes will benefit millions more. But people will lose out if the qualifying earnings rules are applied across the board. The House of Lords should pass these amendments and ensure that millions of pension savers are not short-changed by the Government’s proposals. 

Under the Government’s current proposals around the ‘Qualifying Earnings’ limits for personal accounts, contributions will be paid into personal accounts only on earnings between £5,035 – £33,540, with the employee putting in 4% and the employer 3%, with a further 1% top-up via tax relief. 

Existing workplace and occupational schemes, which in any case have employer contributions of around 6%, calculate contributions based upon the whole basic salary of employees, from the first pound that is earned. The danger with the legislation as currently drafted is that employers could be forced to change scheme rules to accommodate the more limited personal accounts earnings band, leaving millions of consumers short-changed, yet costing the pensions industry millions to implement the changes.