Pension annuities, here's what you need to knowPosted on: 21 September 2017 by 50connect editorial
Annuities often get a bad press but they remain the only instrument that can guarantee an income for the rest of your life explains Peter Brennan.
When you retire you can use your pension fund to buy an annuity from an insurance company. This means exchanging all or part of your pension fund for a regular, guaranteed income. The income is usually paid for life, but you can opt to buy short term annuities, if you prefer.
What are the main advantages of an annuity purchase?
- Guaranteed income – A conventional annuity can provide a guaranteed income for life.
- Flexibility – Insurers compete to provide attractive terms. You should shop around in order to get the best deal possible for your needs.
- Mortality cross subsidy – Part of the annuity rate takes into account the fact that some people will die earlier than statistically expected; the annuity rate takes this into account to give a higher income.
What are the main disadvantages of an annuity purchase?
- Timing – When you buy your annuity, you are locked into the annuity rates available at that time. If annuity rates are poor, your income for the rest of your life will be affected.
- Flexibility – You cannot make any changes to your annuity once it has started.
- Death benefits – Unless you have included a guarantee period, spouse’s pension or value protection, your income will cease on your death. Normally any remaining value will be kept by the annuity provider rather than your family.
- Investment control – If you purchase a conventional annuity, you will lose all investment control of your retirement fund in return for a guaranteed income. As an alternative, investment-linked annuities are available and they can offer a higher income than conventional annuities. However there is a risk if future investment conditions are not met, you could receive a lower income than a conventional annuity
The amount of income you receive from an annuity depends on a number of factors including your age, health and the specific options you choose.
Annuity rates are based on the prevailing yield of government gilts (which is why they have been much lower in recent years).
If you are thinking about purchasing an annuity it’s very important to shop around for the best rate as it’s very unlikely your pension provider will offer you the best rate available. This is called exercising the Open Market Option.
Standard annuity rates assume you are in good health, do not smoke or do not undertake hazardous pursuits. If you suffer from any form of ill health, even if it is controlled through medication, you might be able to obtain a better annuity rate. Lifestyle factors such as smoking or drinking above the recommended number of alcohol units can also increase the amount you receive.
There are a few different options to consider if you are purchasing an annuity:
1. Reducing the impact of inflation
A ‘level annuity’ will stay the same for the rest of your life. If you select this option you will have a higher starting income, but inflation will reduce the purchasing power of your income. If inflation is 2.5% each year, an income of £10,000 will be worth £6,102 in 20 years.
An ‘indexed annuity’ will increase each year, either by a stated amount (2.5% or 3% for example) or in line with the Retail Prices Index. Including Indexation will significantly reduce your initial income, so you should consider the amount of time you will need to live to have received more money than if your retirement income did not increase.
2. Continuing income for your spouse or civil partner
Annuity income will normally stop when you die. If you choose to include a spouse’s pension, they will continue to receive a proportion of your income if you die before them. It’s very important to make provision for your loved ones if your income will provide most of the household expenses.
3. Getting value for money if you die earlier than expected
Whilst statistics show that on average life expectancies are increasing and people are often living for 20+ years once they retire, there is still a chance that you might not live this long. If you were to die earlier than expected, you might have received less retirement income in total than the amount of money you used to pay for the annuity. Any loss to you or your family is a profit retained by your annuity provider.
There are two options you can include to help get value for money: value protection and a guarantee period. You normally cannot select both options; adding value protection will reduce your initial retirement income more than including a guarantee period because the provider is more likely to have to pay out more money in total.
Value protection means that a proportion of the amount of money used to purchase your annuity is guaranteed to be paid out either in the form of retirement income, or as a lump sum ‘balancing’ payment when you die; up to 100% of the annuity purchase amount can be protected.
If you include a guarantee period when you set up your annuity, your retirement income will still be paid for the rest of your life, but if you were to die within this initial period your retirement income would continue to be paid out until the end of the guarantee period at the same level as when you were alive (with any increases which you decided to include). The continuing income would be paid to your nominated beneficiary as pension income. If the balance of the guarantees income is paid to your estate, this income may be subject to Inheritance Tax.
If you have questions on any of the points raised above, please do not hesitate to get in touch.
Peter Brennan is Chartered Financial Planner at EQ Investors, a boutique wealth manager, based in London
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