Annuities

Part of a Prudential annuity statement sent to a client

Purchasing an annuity with your pension fund or funds is currently one of the most difficult financial planning decisions that you have to make.

It will have taken you many years of sacrifice and planning to build up your pension fund(s).

However, once you are ready to take the benefits you have to try to estimate your income requirements and the likely effects of inflation over the next 20 to 30 years.

The decision is made all the more difficult because it is, in the majority of cases, irreversible. With few exceptions, purchasing an annuity is a ‘one-off’ decision.  Once it is made it cannot be changed and you cannot even change the annuity provider. It is important to get it right first time.

Who is affected by this?

You may be fortunate enough to have what is called a defined benefit pension. If so, then at retirement you will automatically receive a pension, usually with some form of inflation linking. Job done.

For most people their pensions from employment or self employment are of the personal pension variety. These are referred to as a defined contribution (also known as ‘money purchase’) pension. With this type of pension plan you (possibly with the help of an employer) are simply building up a fund. At retirement you need to turn that fund into a pension to support you in retirement.

Historically there was no choice at this stage, you would simply turn the fund into income by purchasing an annuity. Now you also have a choice of taking the fund as a single lump sum or leaving it invested and withdrawing what you require each month or year. Depending on the size of the fund you have built up there may be devastating tax charges if you take it as a single lump sum. If you leave it invested and take regular or occasional withdrawals then the risk is that the fund will run out too soon. In both situations you could end up with no further payments from your pension and be dependent on the State pension.

These notes are only concerned with the annuity option. In particular, how to get the very best annuity for your circumstances. After all, you are likely to be receiving it for a very long time.

What is an annuity?

An annuity is a guaranteed fixed income which you buy with a lump sum from funds from your pension plan. Your annuity income may have a fixed term, or more commonly, it may continue until you die or when another named person dies. We could also describe an annuity as an insurance provider’s promise to pay you an income for a set purchase price. 

The most common reason for buying an annuity is retirement. However, they can be bought by any investor requiring income, with a cash lump sum from any source. In that case it would be a ‘purchased life annuity’. 

It is probably fair to say that in the current financial environment, the only people purchasing annuities are those who have to use their pension fund to provide them with some form of income.  If you simply have capital on deposit or in an investment then it is unlikely that you will want to purchase an annuity with that. I have checked at the time of writing this and can find no one willing to quote for purchased life annuities at present.

You purchase an annuity on your life and one of the decisions you will need to make is whether the income should stop when you die or continue being paid to a dependant, such as a spouse.  The insurance provider is taking on a higher risk if payments are to continue to someone else on your death and so a lower income will be offered at the outset.

Another decision you will need to make is whether the income should be fixed or increasing each year.  Again, the insurance provider is taking on a higher risk if you want an increasing income and so a lower income will be offered at the outset.  If you, for example, require an income that increases in line with some measure of the cost of living then this will give you certainty and security, compared with the other options that are available.  On the other hand the insurance provider will have an even greater unknown risk and the initial income level offered will reflect this.

How is the income calculated?

The annuity provider will calculate from your current age and possibly from your state of health how long they think you might live and what return they can obtain on the lump sum you are proposing to invest with them. 

In fact they do not really assess your own life expectancy as that would be too difficult as you might live to be 110 or walk in front of a bus shortly after taking out the annuity.  What they actually do is to use mortality (i.e. life expectancy) tables which estimate the number of deaths each year per 1,000 of the population in each age group. 

In recent years they have had more sophisticated tables which estimate the number of deaths each year per 1,000 of the population in each age group who have had cancer in the last five years, or smoke cigarettes, or are very much overweight, or have high blood pressure etc.

The insurance provider is therefore not really considering your personal life expectancy, but that of a group to which the insurance provider thinks you most closely fit.  They will then quote an income figure which they will maintain for the rest of your life, or for a fixed term if that is your preference.  This is possible because they provide annuities for a large number of people, some of whom will die sooner than expected and some later than expected. This will mean that they can still keep on paying for those who live longer than expected.

In essence annuities are simple, secure and guaranteed. An annuity gives great security and peace of mind as you no longer have to worry about investment returns.  However, if you purchase a level (i.e. non-increasing) annuity you will also have concerns if inflation is high or rising.  Inflation in the UK is very low at present but many commentators give good reasons why inflation is likely to be much higher over the next decade.

Tax free lump sum

Annuity income from a pension fund is taxable. Therefore, before purchasing an annuity it is important to be aware of how much you can take from your pension fund as a tax free lump sum. You should consider the following:

  • The normal rule is that up to 25% of your pension fund can be taken as a tax free lump sum. There is a restriction that if your total pension funds are in excess of the lifetime allowance (£1,073,100 in 2020/21) you can only take up to 25% of this amount (i.e. up to £267,750).
  • What if you have an older pension plan which contains a guaranteed annuity rate? Some of these are in the 6% to 8% pa range. Depending on the rate you might wish to take less or even no tax free cash to get the maximum benefit from the guaranteed rate.

Available annuity options

An annuity is fairly straightforward in that it converts a lump sum (in this case a pension fund) into an income, usually for life. However, there are a number of aspects to the design of the annuity which will each affect the income you receive to a greater or lesser extent.

We have seen that the level of annuity you will be offered is based on the size of your pension fund. More specifically the amount remaining after you have taken any tax free cash sum from the fund. You will be able to control some other aspects of your annuity purchase depending on the design you choose for your annuity. 

The main ‘design aspects’ of your annuity are as follows:

  • Your age
  • Lifetime or fixed term
  • Income frequency
  • Payment in advance or arrears
  • With or without proportion
  • Guaranteed periods
  • Escalation
  • Spouse’s/Partner’s pension
  • With or without overlap

Your age

Your annuity will generally be paid to you for the rest of your life. Therefore your present age and your resulting life expectancy will have the greatest influence on the level of pension available to you.  For example, a 60 year old would receive a lower annuity income than a 70 year old with the same fund size, because the 60 year old will have a longer life expectancy.

Although across the population women tend to live four or five years longer than men of the same age, male and female annuity rates were equalised at the end of 2012 to reflect European legislation.

One of the decisions I will discuss later in these notes is whether you should purchase a ‘single life’ or ‘joint life’ annuity.  This will depend on whether you have a spouse or partner you need to provide for after your death.  If you have a single life annuity, the income you receive will stop if you die before your spouse or partner.  If they have no income provision of their own, this could leave them in a difficult situation which a joint life annuity would help alleviate.  However, as the joint life annuity will be based on your combined life expectancy, the income you receive from this option will be lower.

A simple example of this is shown in Table 1.  The annuity amount assumes £100,000 purchase price (i.e. the pension fund remaining after any tax free cash has been taken), that both people are age 65, in good health and do not smoke, and the annuity is level (i.e. non-increasing) and paid monthly in advance.  For the single life annuity there is a 5 year guarantee. It is assumed that the joint life annuity will continue unaltered to the spouse should the annuitant pre-decease them and there is no guarantee period.

Single or Joint Life Level Annuity £ pa
Single 4,658.98
Joint 4,063.87
TABLE 1 – Figures provided by The Exchange on 05.11.2020 showing the most competitive annuity rate in each case

Income frequency

Annuity income is normally paid monthly, but can be paid less frequently, such as quarterly, half-yearly or even annually.  Income paid monthly in arrears would be slightly less in total over the year than income paid annually in arrears for the simple reason that the annuity provider is holding onto your money for longer and could be expected to obtain a greater investment return.

Some very old personal pension plans and retirement annuities (the previous version of personal pension plans) include guaranteed annuity rates. As a result of the general fall in annuity rates over the last thirty years or so these can be quite beneficial for you if you hold one of these. 

Often, however, any guaranteed annuity rate is only paid annually in arrears and on your life only.  Whether it is in your interests to make use of the higher annuity payments provided will depend on whether you have other pension funds which can provide for your spouse or partner and sufficient other income so that the annually in arrears payment from one annuity is not going to cause you a problem.

Table 2 shows the effect of having the income paid at different intervals in arrears. No proportionate payment will be made if death occurs between payment dates.

Income Interval Single Life Level Annuity £ pa
Monthly 4,677.43
Quarterly 4,695.91
Half Yearly 4,723.70
Annually 4,779.63
TABLE 2 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1
     

If you are going to receive a small annuity payment and you have sufficient income from other sources such as an occupational pension scheme, then you might prefer to have your small annuity paid, say, twice a year so that you can put one payment towards Christmas and the other towards your summer holiday.

With or without proportion

If you decide to have your annuity paid in arrears then you have a supplementary choice to make.  What do you want to happen to the proportion of the annuity payment that you are owed on your death?  Again this will not be an issue if your annuity is paid monthly but if it is paid quarterly, half yearly or annually in arrears then do you want that money paid to your estate?  This is a valuable option for those being paid annually in arrears, since death just before a payment was due could result in considerable loss of income.

If you decide to have your annuity ‘with proportion’ then this final payment will be made to your estate. 

If you elect to have your annuity set up ‘without proportion’ then nothing further will be paid on your death (unless there is a guarantee or the annuity is on a joint life basis). You should get a slightly higher annuity payment for an annuity without proportion but this is not the case at the time of writing these notes as Table 4 shows.

Annual Income in Arrears Single Life Level Annuity £ pa
Without proportion 4,779.63
With proportion 4,779.63
TABLE 4 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1

Guaranteed periods

What if you were unfortunate to die shortly after starting the annuity?  Having saved for years for a decent retirement fund and then purchased an annuity, there is the possibility that you will die much earlier than you might have expected.  The annuity will then end and much of that fund will effectively go to waste.  This encourages some retirees to put off buying an annuity for as long as possible.  The alternative, however, is to purchase an annuity with a guarantee. This guarantees the income will be paid for a set period even if you die earlier, meaning your dependants or heirs will get some benefit from your pension fund.

By including a guaranteed period your annuity will be paid to your estate for the remainder of that period even if you die within that period. Whilst most people opt for a guaranteed period of 5 or 10 years some providers offer a guaranteed period of up to 30 years (or age 100). 

The older you are, and therefore the shorter your expected life span, the more expensive a guaranteed period will become.  Table 5 shows the reduction in your annuity by adding different guaranteed periods.

Monthly Income Single Life Level Annuity £ pa
No guarantee 4,663.86
5 year guarantee 4,658.98
10 year guarantee 4,634.15
15 year guarantee 4,416.00
20 year guarantee 4,298.40
25 year guarantee 4,107.48
30 year guarantee 3,864.36
TABLE 5 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1

You will see that adding a 5 or 10 year guarantee period usually makes little difference to the annuity payments so we would normally advise you to include at least this level of guarantee. 

Escalation

By far the largest numbers of annuities purchased are level (i.e. non escalating).  An escalating or indexed annuity is one that increases each year.  Whilst this is the ideal for anyone purchasing an annuity, choosing this option will result in a considerably lower starting income than having a level annuity.

It is therefore important to carefully balance what you need now against what you are likely to need in the future, and also take into account the age to which you expect to live, based on your health and that of your family.

Inflation as measured by the Consumer Prices Index (CPI) for the year to September 2020 is just 0.5%. However it is important to bear in mind that Government’s target rate for inflation which they have set the Bank of England is 2%. As mentioned earlier, many commentators give good reasons why inflation is likely to be much higher over the next decade. However, even with inflation at a low rate, a fall of just 2% every year in your disposable income could have an important impact over the long term.  Protecting your annuity against inflation will cost you more in the short-term, but may give you peace of mind in the long run.

You can choose to have your annuity linked to the RPI (Retail Prices Index) in which case your income will increase in line with inflation (full inflation proofing). As an alternative some providers offer Limited Price Indexation (LPI) which will ensure that it increases annually by the RPI or 5%, whichever is lower. For simplicity you can opt for a percentage of fixed escalation, usually between 0% and 5% per annum.  Table 6 shows the reduction in your annuity by adding different rates of escalation.

Monthly Income Single Life Annuity £ pa
Level 4,658.98
3% escalation 2,918.04
RPI linked 2,452.92
LPI linked 2,450.04
5% escalation 2,106.60
TABLE 6 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1

As your annuity is to be paid for perhaps 20 or 30 years it is important that you consider the effects of inflation.  There is no easy answer as to whether you should take a level or an escalating annuity.

In favour of using a level annuity is the much higher starting level of the annuity.  In fact it could take 13 years (see chart below) before an annuity escalating at 3% pa pays you the same amount in a year as a level annuity.  In the example shown the person will then be aged 78.  However, it could take 25 years in total (see Table 7) before an annuity escalating at 3% pa pays you the same total amount of income as a level annuity.  By then the client in our example will be age 90 and possibly feel that their income requirements are reducing. 

In favour of using an escalating annuity is the fact that once the annuity has been set up you are unlikely to keep comparing your income to what you might have received under a level annuity.  What you will be pleased to note is that every year you will receive a statement advising you of your slightly higher annuity payments in the year ahead. 

On the other hand it is possible for clients who opt for a level annuity for very sound mathematical reasons to feel emotionally worse off as their annuity stays the sameyear on yearand everything they wish to purchase increases.  Such people may wish that they had made the choice to ‘bite the bullet’ of a lower income to begin with knowing that it will increase each year to provide some protection against inflation.  It is extremely important to consider the effects of inflation on your retirement income.  In times of low inflation you should always consider the potential impact of high inflation on your future income should this occur during your retirement.  It is easy to forget that as recently as 1990, inflation reached 10.9%.

It is important to at least consider what would happen if inflation were to rise to anything near past levels.  As an example, in the period 1970 to 1991, inflation in the UK reduced the value of one pound (RPI adjusted) to just 11 pence.  Or, to put it another way, it would have reduced an annual income of £10,000 to just £1,100.

Case Study Mr A, retiring at 65, is looking at the long-term implications of his retirement income.  For a purchase price of £100,000 he was quoted a gross level annuity, paid monthly in advance, of £4,659 and of £2,918 for one escalating at 3% per annum. 

He calculated that he would probably receive the same cumulative income from the escalating payments as that from a level annuity over his expected life span.  As he is a disciplined saver, he opted for the level annuity, with the intention of saving the difference between the level annuity and the escalating annuity for any unexpected expenses later on in life. 

Any retiree who wants to offset the effects of inflation, and who is not a disciplined saver, should consider some sort of escalation on their pension annuity.

Spouse’s/Partner’s pension

Most couples choose to have a pension that benefits their surviving spouse or partner.  This option means that if you pre-decease your spouse or partner, an income is paid to your surviving spouse or partner for the rest of their life.  This pension can be 100% of your pension or more usually it is 66% or 50% of your pension. 

Your partner need not be your wife or husband; any person of either sex may be eligible for a partner’s pension, although some companies will insist that you can show that person’s financial dependency on you.  Financial dependency may also need to be proven if, and when, the dependant’s annuity comes into payment.  This type of annuity is sometimes called a ‘reversionary pension’ because the income reverts to your spouse or partner if you pre-decease them.  Table 7 shows the annual annuity for different levels of ongoing income to your spouse or partner.

Joint Life Annuity Level Annuity £ pa
50% to spouse 4,300.55
66% to spouse 4,217.04
100% to spouse 4,063.87
TABLE 7 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1
An actual case Mr B was completing annuity papers from Scottish Amicable when I called on him and his wife socially.  He was approaching age 65 and looking forward to his retirement after a particularly hard working life.  He was a very active man, a keen gardener who loved walking in the country. 

Mrs B was not very active and was often ill.  Although this was a social call and Mr B was not a client I could not help noticing that he was applying for a single life annuity. When I queried this he explained that it was most unlikely that Mrs B would outlive him because of her increasingly poor standard of heath. 

You know what I am going to say.  Mr B died suddenly of an aneurism embolism in 1993 when he was aged 78.  Mrs B on the other hand continued a very active social life. She eventually moved into sheltered accommodation and died in 2014. Thankfully, I had managed to persuade Mr B to alter his annuity choice to a joint life annuity with 100% continuing to his wife and that enabled Mrs B to enjoy the benefits of that decision for 21 further years after her husband died.

The chief factor affecting the level of annuity is the age of your spouse or partner.  If they are considerably younger than you, this can have a large impact on your income, especially if you choose a 100% spouse’s pension. 

The need for a spouse’s/partner’s pension will depend very much on the financial circumstances of the spouse/partner.

Spouse’s/Partner’s pension: Case Study  Mr C and Mrs C are married to each other and are both looking to purchase an annuity.  Mr C has been by far the highest earner and has a substantial pension fund.  In view of his cautious attitude to risk he is not interested in anything other than a guaranteed annuity.  Mrs C has mainly worked for companies where there was no pension provision and in view of Mrs C’s large pension fund she did not see the need to do much about her own pension funding. 

Late in life Mrs C realised that this was not an ideal situation and was then only able to build up a modest pension fund of her own. 

A sensible solution could be for Mr C to purchase a joint life annuity with 100% of his pension continuing to his wife should he predecease her. On the other hand it would be quite in order for Mrs C to purchase a single life pension with her modest pension fund as her husband would not be in any financial difficulty in the event that she predeceases him

With or without overlap

If you were to die within the guarantee period, ‘with overlap’ means that your spouse or partner receives their pension immediately and it is paid in addition to the remaining guarantee period pension. ‘Without overlap’ means that your spouse or partner does not receive the spouse’s/partner’s pension until the guaranteed period pension finishes but, of course, they would still be receiving your pension during the remainder of that guarantee period.

A ‘with overlap’ pension is usually only available to retirees from company pension schemes where a 5 year guarantee period and a spouse’s/partner’s pension are required.  However, some providers are now offering this option and it is worth considering if it is available.  Otherwise, all pensions are paid ‘without overlap’. 

Enhanced annuities

If you smoke 10 or more cigarettes a day and have so done for the last 10 years, or you are seriously overweight, or have high blood pressure, you may qualify for enhanced annuity rates.  These rates can add 10% or more to your retirement income.  The reason, of course, is that these factors in 1,000 people would reduce their average life expectancy below that of 1,000 people with no such factors.  If you stop smoking after you have purchased your annuity your income will not be affected provided there is no evidence that you had any intention of stopping at the time your annuity commenced.

Similarly, if you are in ill health or have had any previous illness or major surgery which is likely to reduce your life span, again you may qualify for enhanced annuity rates. 

Table 8 shows a comparison between smoker (15 cigarettes per day) and non-smoker rates.

Monthly Income Single Life Level Annuity £ pa
Non smoker rates 4,658.98
Smoker rates 4,845.72
TABLE 8 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1

It is estimated that 40% of people can qualify for some type of enhancement to their annuity rates.  It is therefore a tragedy that so few people bother to investigate this possibility and simply accept the annuity being offered by their existing pension provider.  If you are including a spouse’s/partner’s pension then their health should also be assessed because it may improve your income.

A recent development is the introduction of the socio-geo-economic annuity.  If you are in a manual occupation or if physical labour accounts for a large part of your work, and you live in certain areas of the UK, you may qualify for this annuity, which tends to offer a higher annuity rate than the top standard annuity rate available.

Some annuity rates can be affected simply by your postcode.  Table 9 shows the different annuity rates for those living in Guildford (Surrey) and Warrington (Cheshire).

Address of Annuitant Single Life Level Annuity £ pa
Guildford 4,658.98
Warrington 4,872.48
TABLE 9 –  Figures provided by The Exchange on 05.11.2020 using the same basic client and annuity details as in Table 1

Whilst enhanced annuities offer the prospect of a higher pension for a good number of people who are retiring, a much smaller number may qualify for an ‘impaired life’ annuity.  These types of annuities can take longer to set up than normal, as correspondence between your doctor and the annuity companies will often increase the administration time by a few weeks.  The illnesses include diabetes, liver impairment, hypertension which cannot be controlled by medication, heart conditions and any type of cancer, whether or not you are in remission.  Some illnesses can result in a significant increase in your income. 

In very broad terms an impaired life annuity might be offered to someone with a life-shortening condition which meant that there was a high risk of death within the next five years, whereas an enhanced annuity might be offered to someone whose health or lifestyle meant that their life expectancy was reduced but not to such an extent.

Applying for an impaired life annuity can be time consuming because pensions providers normally require detailed medical evidence, sometimes requiring a medical examination and underwrite each application individually.  On the other hand applying for an enhanced annuity is fairly straightforward with simplified application procedures.

I do not want to leave you with the perception that your condition would have to be serious before it would have any impact on the amount of income you might receive from an annuity.  In reality, conditions that you may have lived with for years and regard as a part of your normal daily life such as asthma or diabetes could have more of an effect than you might expect – particularly if you have a combination of conditions.  The presence of multiple conditions can raise the level of enhancement on offer. 

There are well over 1,500 conditions that could qualify for an enhancement.  The types of condition that are considered are not always obvious.  For example, you may be taking medication for high blood pressure or high cholesterol and you may not realise that it is important to declare these types of medication. 

Investment linked annuity

A investment linked annuity moves away from the simple, secure and guaranteed nature of annuities that we have considered so far.  With an investment linked annuity, as its name suggests, you accept a lower initial income in exchange for sharing in the potential investment growth produced by the annuity fund. 

Investment linked annuities invest your money into stocks and shares on the basis that investment growth could offer the potential for higher income payments in the future without the need for you to buy inflation protection.  There are risks to this approach, however, as your investment might not grow – indeed it might actually fall. Then, even if the investment does grow, it may not grow in line with what you expect – so either your income will then have to be cut or will be maintained but start to eat into the capital value of your investment.  If that possibility concerns you at all, you should stick to conventional annuities.

An added feature is that some future growth can be discounted to give you a higher initial income level.  If investments do well, this could provide you with an increasing income in the long term.  However, if investments do not do as well as expected, your income may fall.

Even if your income is based on an assumed growth rate of 0%, your income could still fall if the value of the underlying investment fund falls.

With profits annuity

A with profits annuity is a form of unit linked annuity but where the underlying fund is the annuity provider’s with profits fund.  With profits annuities do provide an element of ‘smoothing’ to the investment returns.  The idea is that in years in which investment returns are poor your income will not necessarily go down as much as the underlying investments have gone down.  It also means that in very good years not all of the investment return is paid out as some is retained to cover the poor years. 

In practice, however, with profits annuity providers use a combination of annual and terminal bonuses to determine the annuity level each year and the year which follows one where a large terminal bonus was included can result in a large fall in the annuity income.

A with profits annuity can be a good alternative to an RPI linked annuity because they both start at a similarly low level but, historically, with profits bonuses from the major pensions offices have outperformed inflation over the long term.

Low risk clients who want an increasing income from their annuity can still use a with profits annuity but should not select an anticipated bonus rate (i.e. it should be 0%).  In this way although their annuity can still fall because of the reasons given earlier, it cannot fall below the level that it was at the outset.

Less risk averse clients can normally select an anticipated bonus rate.  The minimum and maximum rates of anticipated bonus rate you can choose vary by provider, but typically, the range is from 0% to 5%.  If you were to choose an anticipated bonus rate of 3% for example and the actual bonus rate was 2% then your income would fall by 1%.  However, if there was a 5% terminal bonus added in the previous year which no longer applies then the fall in your income would be nearer 6%.

Fixed term annuity

Rather than purchasing an annuity for life you can use your pension fund to buy an annuity for a fixed term of up to 25 years.

There are two types of fixed term annuity:

  • Firstly where the income is paid for the fixed term and that is the end of the annuity with no further payments. This type of annuity is useful when you believe that you will need a higher pension income until a certain age and you are willing to see your income reduce after that time.
  • Secondly where the income is paid for the fixed term after which you receive a known lump sum. You can set the balance that is right for you between the regular income amount and the lump sum ‘maturity’ value. This creates options for you later in retirement. At the end, you can use the lump sum as you see fit. If your health was to deteriorate by the end of the plan you may be able to buy an annuity at a better rate. You can choose for your beneficiary to receive any remaining income payments and the maturity value if you die during the plan.

Open market option

Over the years, you will have worked hard to build up your pension fund(s). As you near your stated retirement age the pension provider will write to you offering a range of annuity options, one of which will be an ‘open market option’.  This is important as it allows you to take your retirement fund to a different provider than the one with whom you have actually built up your fund.

Using the open market option will more often than not lead to an increase in your annuity. It is now a legal requirement to ensure you are made aware of what your open market option will be. Far too many people simply take the annuity offered to them.  However, it is your right to arrange your annuity with any other pensions office if you can get a higher annuity rate.

Please remember that you may only get, say, £10 per month more, but that £120 a year is for the rest of your life and is at no cost to you except for a little additional paperwork.

Getting guidance or advice

When you reach the retirement age specified under your personal pension contract, your pensions provider will write to you offering various ‘annuity’ options.  At that stage you should get some help so that you fully understand your options.

You can get free guidance from Pension Wise which was set up by the Government.

If you have a reasonably substantial pension fund you should get advice from an independent financial adviser (IFA) so that they can investigate whether a higher, or more appropriate, annuity can be arranged for you, or indeed, whether an annuity should be used at all.

The tax situation

We have seen that you can take up to 25% of your pension fund as a tax free cash amount (Pension Commencement Lump Sum).  This applies if you have some form of private pension arrangement such as a personal pension plan, stakeholder pension plan or SIPP (self invested personal pension).  If you have benefits in an occupational pension scheme (which includes an executive pension plan) there may be some other formula for working out the lump sum. 

The rest of your pension will have to provide income and so will be taxed as earned income.  It does not matter whether this income is provided by means of an annuity or income drawdown, the tax treatment is the same.  The only difference with income drawdown is that you are able to adjust the level of income you drawdown to achieve the most tax efficient outcome. 

For example you could reduce your drawndown income to keep yourself below the higher rate tax band or drawdown no income in a year in which you make a large capital gain from, say, the sale of a second property.

You can use your personal allowance to reduce the amount of tax due.  It is usually thought to be best to take the tax-free cash rather than use it to buy a larger annuity because the annuity is taxed.  However, this might not be the best option if your pension provider offers a high guaranteed annuity rate.

Summary for and against

An annuity is especially attractive in the following situations:

  • You want to receive a guaranteed level of income for life.  
  • You wish to have the certainty of a guaranteed income for the rest of your life and that of any financial dependent.  
  • You are prepared to make the decision once and for all with no options to change in future.  
  • You want your payments to be made for a guaranteed period of time (usually for 5 or 10 years but can be up to 30 years or age 100 if earlier). This means that, should you die within this period, payments will continue to be made.  
  • You want to be able to take a tax-free cash sum immediately (although you will receive a lower annuity payment) to spend or invest as you wish.  
  • You may be required to pay for advice now but there will be no need for further advice regarding the annuity as no changes can be made. So this is a cost effective option.  (Although you may wish to receive advice on other areas of your financial planning.)

It is important to be aware of the possible drawbacks as follows:

Advantages of a With Profits Annuity

  • By using a With Profits Annuity your income will never fall below a certain amount.  
  • In the long run your income could even grow faster than inflation, although this would entirely depend upon the relevant funds’ performance, inflation levels and the anticipated bonus rate selected.

Disadvantages of a With Profits Annuity

  • Your income could decrease to a level lower than you had in the beginning.
  • Unlike an escalating annuity, there is no guarantee of a rising level of income.  
  • Past performance is not a guide to future performance.  

Links for further information

 

Important

This information does not constitute personal advice and should not be treated as a substitute for specific advice based on your circumstances.

Information given relating to tax legislation is based on my understanding of legislation and practice currently in force. Whilst I believe my interpretation of current law and practice to be correct in these areas, I cannot be responsible for the effects of any future legislation or any change in interpretation or treatment. In particular you are warned that levels of tax and tax reliefs are subject to alteration and, in any case, the value of such reliefs and benefits may depend on an individual’s circumstances.

If you are in any doubt as to whether any course of action is suitable for you, then you should discuss the matter with a suitably qualified independent financial adviser or other specialist.