An annuity is a financial product where you exchange a lump sum for income. In the case of pension schemes, you usually exchange your pension fund for an income payable for the rest of your life, often called a compulsory purchase annuity.
Rates are set by insurance companies and typically expressed as a sum per £10,000 or £100,000 of lump sum. So, for example, a 65-year-old man might be quoted a rate of, say, £350 income for every £10,000 of lump sum.
The major drawback with annuities is that once you’ve handed the money over, you can’t get it back. And if you die soon after buying the annuity, then the income you receive won’t be anywhere near the amount you’ve paid in. However, there are steps you can take to protect yourself – see the annuity options below.
Who needs to buy an annuity?
Anyone who has a lump sum and wants to convert this into an income can buy an annuity, but most people come across them for the first time when they’re coming up to retirement and need to convert all or part of their pension fund into an income.
You’ll be offered the chance to buy an annuity with funds from any personal pensions, stakeholder pensions and most money-purchase employer schemes. The type of annuity you buy with your pension fund money is called a compulsory purchase annuity. We also refer to these as pension annuities.
You will need to work out what your financial priorities to see what type of annuity is best for you.
When you buy a pension annuity, you exchange a lump sum for an income payable for the rest of your life. However, the type of income you decide to have will make a big difference to the amount you receive.
The main factors to consider are:
- Whether you want protection against inflation during retirement
- How much risk you are prepared to take
- Whether anyone else is dependent on you
- How much flexibility you need to change your pension after it has started to be paid
- How much control you want over your investments
- What charges you will need to pay
- Whether you want to provide an inheritance for your survivors
- What your general state of health is and whether you are or have been a smoker
Depending on your answer to the above considerations, you may want to consider Income Drawdown as an alternative.
Level or increasing annuity?
You’ll need to decide whether or not you want your income to increase each year. You can buy an annuity that increases with inflation, or one that’s set to rise by a fixed percentage each year. Alternatively, opt for a level annuity, which will provide exactly the same income each year.
Level annuities are the most popular type, probably because they offer the highest starting income, but they do leave you vulnerable to inflation. Remember that a 4% rate of annual inflation will halve the buying power of an annuity in 18 years. However, if you buy an annuity with protection against inflation, you’ll have to accept a lower starting income. Although your income increases over time, it might be many years before it catches up with a level annuity.
You probably need to think about your plans for retirement before deciding whether or not you want an increasing annuity. Do you want to maximise your income during the early, healthiest years of your retirement, or do you want equal purchasing power over the years?
It’s important that you decide whether your pension will protect your partner as well. Your answers may depend on your health and how long you expect to live. If you have an existing medical condition, you may be able to get an even higher rate with an enhanced annuity.
An annuity with an annual 3% escalation could reduce a 65-year-old man’s initial pension by around 25%. He would need to survive for around 20 years to make this option better value than the equivalent level pension.
Single or joint life annuity?
The next decision is whether you want an annuity that covers you alone, or one that protects your partner as well should you die first, often known as a survivor’s pension. A single life annuity pays you an income until you die, but if you’re part of a couple and die first, this could mean that your partner is left short of money.
A joint life annuity continues to pay some or all of the annuity income to your partner when you die. A joint life annuity will typically pay around 50% to 67% of your annuity income to your partner after your death.
There are, of course, some trade-offs for this extra provision. Because a joint life annuity will continue to be paid after you’re dead, the rates offered are lower. The higher the proportion of your annuity income that you choose to be paid after your death, the lower the initial income paid by your policy.
Furthermore, if your partner is younger than you, the insurance company will offer a lower annuity rate, as they expect to be paying out for longer.
Where an annuity has a guarantee period, it will be paid out for a set time period, usually five or 10 years, even if you die during that time. If you do die during the guarantee period, the payments may continue as an income to your survivor(s) for the remainder of the period, or can sometimes be rolled into a lump sum.
An annuity with a guarantee is sometimes seen as a substitute for a joint life annuity. But it’s not the same, as the maximum guarantee period is only 10 years. As a result, it won’t fully protect your dependants in the long term.
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