A Short Guide to Annuities

With Pension Freedoms and the increasing popularity of drawdown, annuities have become sidelined. But an annuity can offer valuable guarantees and could still have a place in your retirement plan.

In this guide, we explain the main features of an annuity to help you decide if it could be for you.

How Does an Annuity Work?

When you reach retirement, you can use some of your pension funds to buy an annuity. This is a kind of reverse insurance contract – the annuity provider receives a lump sum from your pension and provides you with a guaranteed regular income in exchange.

A lifetime annuity will pay out this income for the rest of your life.

A fixed-term annuity provides a guaranteed income for several years. This will normally use up a portion of your pension fund, with the remainder staying invested so that you can review your options at a later date.

Most pensions allow you to take 25% of your fund as a tax-free lump sum. Usually, the annuity purchase amount is taken from the remaining 75%.

Annuity payments are taxed at your marginal rate.

What Options Can Be Added?

You can include different options within your annuity, for example:

• A spouse’s pension to be paid out if you die.
• Capital guarantees so that some of your pension fund would be returned to your estate if you were to die within 5 or 10 years.
• Index linking so that your income keeps up with inflation.
• Your income can be paid monthly, quarterly, or annually.
• It can be paid either in advance or in arrears. For example, if you opted for an annual annuity paid in arrears, you would receive your first payment one year after the contract started. The payment would be higher than if you had opted for an advance payment, as the insurance company has had more time to invest the money.

Adding a spouse’s pension or inflation linking to your annuity will make it more expensive, resulting in a lower income. So while an index-linked annuity would increase every year, the starting amount would be much lower than if you opted for a level annuity.

The basis of your annuity is fixed at the outset and cannot be altered later if your circumstances change. However, annuity contracts come with a cancellation period, which means that you can change your mind in the early days of the contract. The cancellation period is normally 30 days, but it’s best to check this with the provider before you proceed.

Factors that Can Affect Your Annuity Rate

Your annuity rate will depend on the following:

• Your age.
• Any options added.
• Your health and/or lifestyle.
• Guaranteed annuity rates included within your existing pension.

Annuity rates tend to increase with age, simply because the insurer expects to pay out for a shorter period.

Additionally, if you have medical issues or are a smoker, you could receive a higher annuity rate due to a reduced life expectancy.

Since 2012, annuity rates must be calculated on a unisex basis, so your rate will not be affected by gender.

It is always worth shopping around for the best rate based on your own situation, rather than simply accepting the income offered by your pension provider.

What Are the Benefits?

There are several benefits to buying an annuity:

• Certainty over your monthly income.
• Your pension would no longer be subject to investment fluctuations.
• They are simple to manage once set up, with no requirement for regular reviews.
• They can provide your spouse or partner with a guaranteed income in the event of your death.

Potential Disadvantages

Of course, annuities are not always suitable. Some possible downsides are:

• Annuities are inflexible. Once they are set up they cannot be changed.
• You cannot withdraw a lump sum, change your income amount, or switch the income off temporarily.
• If you have opted for a spouse’s pension, it’s not possible to change this even if your spouse dies before you.
• Your pension fund could not benefit your children, unless you add capital guarantees and die within the first five or ten years (depending on the guarantee selected).
• No possibility of benefiting from future investment growth.
• No control over your tax bill.

When Are Annuities the Best Option?

An annuity might suit you if:

• You require a fixed, regular income.
• You do not want to expose your pension fund to investment risk once you retire.
• You have other funds that you can use to provide flexibility or cover lump sum expenses.
• You do not want to pass your pension fund on to your children.

What Else Can You Do with Your Retirement Fund?

Of course, annuities are not the only option and do not need to be used in isolation. Some other possibilities are:

Flexi-Access Drawdown

This allows you to draw money from your pension as and when you need it, combining tax-free cash and taxable income. This can help to keep your tax bill under control and means that the money you don’t need immediately is kept in a tax-efficient pension wrapper.

If you place your funds in drawdown now, there is nothing stopping you from buying an annuity later in life. This can improve the rates available, particularly if you develop any health issues. Of course, rates change all the time, so there is no guarantee that they will be higher in the future.

Uncrystallised Pension Fund Lump Sum (UPFLS)

This is the process of taking a lump sum from your pension, comprised of a 25% tax-free lump sum and 75% taxable income. You can take your entire pension pot in this way, but it could be more tax efficient to phase the withdrawals over a number of years. Remember that the 75% will be taxed at your full marginal rate and may push your income into a higher tax band.

Combination

If you need a fixed amount each month to pay the bills, you could use part of your pension pot to buy an annuity. This makes sure the essentials are covered, while allowing the remainder of your fund to continue growing. Any ad hoc or luxury expenses can be covered by taking flexi-access drawdown from your invested pot.

Do Nothing

If you don’t need an income right away, it can be efficient to leave your fund invested. Pensions benefit from tax-free investment growth and can be passed on to your beneficiaries in full if you die before age 75 (or taxed at their personal rates if you die after 75 and assuming beneficiary drawdown is available).

If you can live on your other income, cash, and investments for a while, there is no need to rush into making any decisions. Your options remain open to you when you are ready.

Please don’t hesitate to contact a member of the team to find out more about your retirement options.

The value of investments can fall as well as rise and is not guaranteed. Past performance is not a guide to future performance.