Annuities
What is an annuity?
An annuity is the eventual home for your pension fund. Money that is built up inside your pension over your working lifetime, through your regular contributions and growth of the assets, will eventually be used to purchase an annuity when you reach your selected retirement age.
You can use part of your pension fund to take a tax-free cash lump sum - usually up to 25% of the total value of the pension fund you have built up. The remainder will be used to purchase an annuity, an income for life.
How can I maximise my income from an annuity?
The annuity product will be provided by an insurer. However the key to maximising your income in retirement is to realise that you can choose which insurer will provide the most income for you.
You do not have to buy an annuity from the insurer that holds your pension. You can use your pension assets to purchase an annuity from any insurer on the market.
This is important becasue many people approaching retirement will receive a letter from their insurer detailing how they will arrange for their pension to be converted to an income for life. Taking this simple option often results in people securing a much lower income for themselves than they could have got if they had shopped around for better quotes.
You can shop around for better quotes online using the FSA's annuity comparison table. Click here to compare rates.
Once an annuity has been bought it cannot be changed or moved so it’s important to make the right choices for your annuity purchase.
The market has begun to respond to this rather inflexible approach and started to offer more options on retirement. So before you make use of your pension fund to provide you an income for life do remember to do some homework about the choices that are available to you.
The level of income the annuity would pay out will be affected by your age, health, whether you smoke and the size of the lump sum you have built up in your pension, as well as some of the options you take on your product at the time.
Types of annuity...
You can buy an annuity with your pension fund anywhere between the ages of 50 and 75 (55-75 after April 2010).
There are several different types of annuity. These include a level annuity, increasing annuity, guaranteed annuity, investment-linked annuity, impaired annuity and joint-life annuity.
Level annuity will pay the same level of income each and every year. Although it will never go down, it will never increase either. The danger with this type of annuity is that inflation can make the value of the income being paid worth less than when the annuity was first taken out e.g. £100 now buys you a lot less than £100 could have bought you 20 years ago.
Increasing annuity is used to guard against the effects of inflation. You can choose for your annuity income to increase in line with inflation, or by more each year. Although the initial income you will be paid may be lower, the fact that it will increase each year should provide comfort that your ability to maintain the same standard of living will remain.
Guaranteed annuity will promise to pay the annuity income for a minimum period of time. Normally when the person taking out an annuity passes away the annuity contract will cease and the insurer will stop paying the income. To ensure any beneficiaries or dependents left behind continue to receive the income even after you pass away, you can include an option to guarantee the income will continue to be paid out for, say 5 or 10 years.
Investment linked annuity is a riskier option and involves linking the value of your future pension income to the rises and falls in the stock market.
Impaired or Enhanced annuity is available to those that have health problems that may reduce their life expectancy. If this is the case then this type of annuity could secure you a higher income than a normal annuity might.
Joint-life annuity allows you to include your partner to benefit from a future income if you were to pass away before them. Should this be the case then the annuity provider would continue to pay your partner a proportion of the income you were receiving at the time you passed away. The level of this proportion, say 33% or 50% of the full icnome amount, can be set by you when you make your application.
Other pension income options...
Drawdown/unsecured pension - this option allows you to keep your pension fund invested and to withdraw a regular income from the fund. Although you have not officially 'taken' your income, or used the entire fund to purchase an annuity, you can still take your 25% tax-free cash lump sum at the point you begin to take an income from your pension fund. This type of option does involve significant risk so you should consider the implications fully before opting for this type of arrangement.
Over 75? - there are some alternatively secured pension arrangements available but these will appeal to very few and the rules surrounding these are complex.
Value protection - many people taking out an annuity are understandably concerned about what will happen to the fund if they pass away shortly after handing over their pension fund to the insurer. Taking this type of option will provide peace of mind that up to 100% of the value of your pension fund that you used to purchase your annuity would be returned to your estate on death.
Tax levels, bases or reliefs referred to are those currently applying but are subject to change. The tax treatment of investments will depend on the individual circumstances of the investor.
