Annuities

An annuity provides an income, either for life or for a specified period, in exchange for a lump sum investment.

Once the annuity has been bought, you cannot get your lump sum back and you are tied into the income agreed. The most common type of annuity is a Pension Lifetime Annuity (also known as Secured Pension) – i.e. at the point of retirement where the pension fund is used to purchase an income for life.

The level of income that you will receive from an annuity depends upon a number of factors:

• How much you invest
• Your age
• Your health
• Sex
• The prevailing annuity rates at the time you invest

Generally speaking, the older you are the more pension annuity (income) you will receive. Once you’ve bought an annuity, the income you will receive will be for either the rest of your life or the term of the annuity. The joker in the pack, however, is the fact that annuity income rates vary so much over time and from provider to provider, just like bank and building society rates.

What happens to my pension when I retire?

It is often thought that a pension starts to pay out once you retire, but that needn’t be the case.

A pension is simply a pot of money. The general principle is that this pot is used to provide you with an income in retirement, but nowadays there are a variety of ways in which this can be done.

If you retire at 65 and you’re a man, you can expect to live until you’re 84. If you’re a woman you can expect to live even longer – until you’re 87. So your income may need to last a long time.

How best to get an income from your pension is a vitally important decision, and taking professional advice on this issue is crucial.

What are my choices?

The government has rules in place about what you can and cannot do with your pension pot, primarily because they don’t want anyone to run out of money.

Cash: The first choice normally made is whether or not to take some of the pension pot as a cash lump sum, which is completely tax-free. You can spend this however you want. It can be used to pay off debts, buy a new car, pay for a holiday etc., or alternatively you may just wish to invest it so that you have a sum under your control. Usually you can take up to a quarter of your fund as a cash sum.

Income: The remainder of your pot must be used either to provide a regular income, or remain invested so that you can take an income at a later date. For most people there are two main alternatives – either buy an Annuity or use Drawdown.

Annuity –

An annuity is a guaranteed income paid for the rest of your life. In practice you swop the pension pot (before or after taking some as cash) for the promise of a regular income.

Pros:

• it’s low risk.
• it pays a regular income no matter how long you live.
• you can choose to provide for your spouse/partner or dependants.
• you can choose to protect your income against inflation.

Cons:

• once you’ve bought it, you can’t cash it in, swop it for anything else, or alter your annuity options.
• the level of income isn’t flexible.
• if you die early, you may get back less than you paid in (although there are options that can help prevent this).
• unless you choose otherwise, your spouse/partner will not be protected.
• unless you choose otherwise, your income will not be protected against inflation.
• the options you choose will affect the level of income you receive – Generally, the more options you add, the more it will cost, so the lower your income will be.

Drawdown (also known as Unsecured Pension or USP) –

This is an alternative to buying an annuity. Your pension pot (before or after taking some as cash) stays invested, but you can choose to take some out as a regular income. The amount you can take is limited by the government – to reduce the risk of you running out of money.

Pros:

• it’s flexible. You can vary the income each year. In fact you don’t evenhave to take anything if you don’t need to.
• you are in control of where your pot is invested.
• if annuity rates are low, you don’t have to buy an annuity straight away.
• your pension pot stays invested in a favourable tax environment.
• when you die, you can leave the remainder of your pot to your spouse/partner or dependants. They will have some choices as to how to take the money. If it’s taken as a cash sum there will be a tax charge (currently 35%).

Cons:

• you can only use this option up to age 75. By then you will need to either buy an annuity, or take an income through ASP (see below).
• you need quite a big pension pot to make this option viable – typically a minimum of £100,000.
• because your pension pot is still invested, it could go down in value, and when you come to buy your annuity later, the income could be lower.
• your pension pot needs to grow to make up for the income you take out – otherwise you will eat into the fund and there will be less there later to buy you an annuity.
• if you take out the maximum allowed each year, there’s a greater chance that your fund will go down in the long term, and when you come to buy your annuity it could be lower.

Alternatively Secured Pension (ASP) –

This is an option if you want to remain in a Drawdown arrangement after age 75 rather than buying an annuity. As before, the money remains invested, but a certain amount must be withdrawn to pay for your retirement. The minimum and maximum amounts that you can take are set by the government.

Pros:

• it’s flexible – you can vary the income each year.
• you are in control of where your pension pot is invested.
• your pension pot stays invested in a favourable tax environment.
• when you die, the remaining money in the pot can continue to be paid as an income to your dependants.

Cons:

• you need quite a big pension pot to make this option viable – typically a minimum of £100,000.
• your income is likely to be lower than the income you could buy with an annuity.
• because your pension pot is still invested, it could go down in value.
• your pension pot needs to grow to make up for the income you take out – otherwise you will eat into the fund and it could eventually run out.
• if you choose to pass on the money to others on your death, Inheritance Tax and other charges may apply.

Is an annuity right for me?

Yes:

• I want a regular income
• I want a guaranteed level of income
• I want an income for the rest of my life

No:

• I want to take out income as and when I need it
• I want flexibility over the level of income I take
• Flexibility is more important to me than security

How much income will I get?

Annuity rates fluctuate fairly regularly, like interest rates on a savings account. As well as the size of your pension pot, and the annuity rates current at the time, there are other factors that come into play in determining how much income you will receive:

• Your sex – a man will generally get a higher income than a woman of the same age with the same size of pension pot, because on average, women live longer than men.
• Your age – the older you are when you buy the annuity, the higher the income is likely to be, because on average an older person will not live as long as a younger one.
• Your health – anyone with a medical condition, e.g. someone who is a heavy smoker or has suffered a previous heart attack, may often secure higher rates since the annuity provider will expect to pay out for a shorter time. These are called ‘enhanced rates’ and increases of 10% – 20% are not uncommon.
• The options you choose to add to your annuity – the more options and guarantees you add, the lower level of income you will get.

What’s the Open Market Option?

If you were buying a house or a car, you’d spend some time looking at the market to decide what’s most suitable and offers the best value. Buying an annuity is probably one of the biggest purchases you’re ever likely to make, so it’s important to make the right decision.

Although your pension company may offer an annuity, it may not necessarily pay the best rates. You don’t have to buy an annuity from them. Different insurance companies offer different rates on their annuities, which can make a huge difference to the income you receive. Sometimes the income on offer from different companies can vary by more than 20%.

When taking the benefits from a pension fund, the permutations available are many and varied, and taking professional advice is crucial as the decisions made are irrevocable. We can explain the options to you in detail and help you decide on the most appropriate type for your circumstances. We can also search the market and compare what companies are offering, to find you the best annuity rate available.

It can take longer than you think to set up an annuity, particularly if you have more than one pension plan. Leave yourself plenty of time – ideally you should get in touch with us at least 3 months before the date that you want to start receiving your income.