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Annuity Purchase Guide


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Annuities are the way most of us will create an income in retirement. This guide explains how annuities work, what your annuity options are and why it is important to make the right choice when purchasing an annuity.

What is an annuity?

An annuity is a financial product that converts capital into income. You hand over a lump sum of money in return for a stream of income payable for a defined period of time, or, as is often the case, until your death.

There are two basic types of annuity - those that you choose to buy but are not required to buy, known as purchased life annuities; and those that are purchased with funds from a pension scheme, known as scheme annuities or compulsory annuities. This guide focuses on compulsory annuities.

Whether you are considering investing a lump sum in a purchased life annuity or whether you are looking to make arrangements for creating income in retirement through annuity purchase, it is vital to shop around and find the best annuity and the best annuity provider for your circumstances. An independent financial adviser (IFA) will be able to assist you in reviewing your financial circumstances and direct you towards your best options.

Annuity rates can vary up to 25% between annuity providers. Let us help you find the right annuity for you.

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How do annuities work?

When you buy an annuity, the income you receive consists partly of interest on your capital and partly of a return of your capital. All the income you get from a pension scheme annuity or compulsory annuity is taxable as earned income. The tax treatment of purchased life annuities is different.

Your pension is liable to income tax at your individual tax rate(s) and will be taxed at source by the annuity provider. Any pension payment due after your death, particularly payments due under any guarantee options will form part of your estate, which could be liable to Inheritance Tax if your total estate exceeds the IHT limit.

The level of income you receive from your annuity is usually quoted as an annual percentage return on the sum you have. Thus an annuity offering a rate of 7% would mean that to create an annual income of £7,000 you would need to have a pension fund worth £100,000. It will be affected by a number of factors. The two most important are long-term interest rates on government bonds (Gilts) and your life expectancy.

There is a direct correlation between the general level of annuity rates - the percentage return on offer - and the performance of Gilts in the financial markets.

How long you are likely to stick around to receive the income from your annuity will also have an impact on how much a life assurance company will be prepared to pay. Life assurance companies have to calculate the annuity rates they offer people on the basis that some people will live longer than others.

The trick, from the individual's perspective, is to live long enough so that the sum total of the monthly payments you receive in retirement ends up being greater than the value of the original lump sum you handed over.

Those people who die fairly early actually subsidise the annuity rates for those who live longer. But as average life expectancy rises over time, companies have to adjust annuity rates to take account of the fact that people are living longer.

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What is the Open Market Option?

The Open Market Option is the first of two basic rules to remember about annuity purchase when you are looking to create an income in retirement. It is known in the financial services business as OMO. This acronym is not a washing powder! Quite simply what it means is that you are not required to purchase your compulsory annuities from the life assurance company that has run your pension savings plan.

This is good news for you. It is generally accepted that the returns offered by different annuity providers can and do vary markedly. The difference between the highest and lowest paying annuities can be as much as 25% in terms of the cash you would actually receive.

Introduced in the Finance Act 1978, the Open Market Option allows you to transfer your pension fund from one life assurance company to another to get a better, higher annuity rate. You must exercise an Open Market Option before any benefits are drawn from your existing life assurance company in the form of an income or lump sum.

Although OMO has been around a while, it is only since 2002 that companies have been obliged actually to point out to those approaching retirement that it is available to them. Your life assurance company will also tell you that you "might get a better deal in retirement" from a competitor. In other words, you are actively being encouraged to shop around to get the best deal for yourself.

Not sure about your annuity choices? Call us for impartial independent financial advice.

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Can I get a refund if I pick the wrong annuity?

In a word, No! Generally speaking once you have bought an annuity there is no way back - you have permanently exchanged your pension fund for a lifetime income. Quite simply the decision to buy an annuity is going to be the single biggest and most important financial decision of your life.

Following the A Day pensions law changes, assurance companies are able to offer a wider range of annuities, including limited period annuities that run for a set length of time or money back annuities (also known as value protected annuities) that return funds on your death less payments already made, and less 35% tax. Bear in mind that any such bells and whistles or special features on your annuity will have the effect of driving down the return on your funds that it is likely to offer.

Once you are in the process of purchasing an annuity, your independent financial adviser will provide you with quotations from annuity providers. It is normal that most providers only guarantee their quotations for a short period of time. In total, you will have at least 30 days after you receive the first quotation to consider whether to proceed. Once you have sent back the application form and the annuity has been set up the decision will be final. You will not be able to change your mind.

Your pension fund may be worth less than your house but if you don't like your house you can always sell it and move. If you don't like the annuity you have purchased, then tough. An annuity purchase is irrevocable. For this reason it is imperative that you get it right.

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When do I have to buy an annuity?

If you are among the diminishing band of people with a final salary pension then you won't ever have to worry about annuities. However, chances are, unless you are a civil servant or an MP that you won't be in that number.

When you save for your retirement through any kind of pension plan, the money you put in is free of tax and then grows tax efficiently. This is very generous of the government but this is as far as its generosity extends. You might think that the accumulated pension pot is your money to do with as you please. You would be wrong!

You may take part of your pension savings as a tax-free lump sum (now officially known as a pension commencement lump sum or PCLS) up to 25% of the value of your pension funds.

You are no longer required to purchase an annuity with the remainder of your pension funds but there are strict rules and potential tax charges in place that hedge round what you can do with the money. The government's view is that we all get generous tax breaks to save for our pensions and that any money so accumulated should be used to create a pension rather than as a form of saving for our heirs.

You may opt instead of an annuity to take an Unsecured Pension this is the post A Day form of income draw down, whereby you can take up to 25% of your fund as a PCLS and leave the balance invested. You may then take an income, if you wish each year, of between zero and 120% of what a level, standard annuity would pay to someone of your age.

After age 75, you may continue doing a more restricted form of income draw down, called taking an 'Alternatively Secured Pension' or ASP. This allows you to take an annual income of between 0-70% of what a standard level annuity would pay a 75 year old, however old you are. This means that your income will not rise in line with your age.

Leaving your pension funds invested means you are potentially at risk from adverse moves in the market value of what your savings are invested in. This can be a highly risky strategy. It is imperative that you make sure you get independent financial advice.

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What should influence my choice of annuity?

You need to think about more than your current income requirement. How much money will you need in future? Will you need to make provision for your husband or wife or civil partner as well? Are you planning to take a pension commencement lump sum from your pension pot - doing so will reduce the amount of money available for annuity purchase.

In addition to a basic income for you in retirement, your pension fund can also be used to buy a number of additional annuity benefits, such as pensions for dependants, guarantee periods, etc. The basic annuity offers a set level income that will not change. However, in addition to extra benefits you may also elect to purchase an annuity that pays more over time.

However, it is important to remember that the more "additional benefits" you wish your pension to provide, the lower your actual income is likely to be. This is because each of these benefits has a cost, which reduces the proportion of your annuity that is available to provide you with an income. Once the annuity has started you may not change the benefits selected, which means it's important you consider your options very carefully.

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What kind of annuity income may I choose?

You may choose between a single life pension and a joint life pension. A single life pension will be paid to you for your lifetime, but stops on your death. A joint life pension will provide you with a pension for your lifetime and on your death, provide a second pension to your dependants for their lifetime.

Your dependants are usually your spouse or partner. However, you may also be able to provide a pension for any child under the age of 18 or still in full time education, or any person who is financially dependant on you.

The dependant's pension may be at the same level as your pension or may reduce to a set fraction of the pension being paid to you at the time you die. You may also be able to arrange for a dependant's pension to stop on his or her remarriage.

Do you need unbiased independent financial advice about annuities? Why not give us a call?

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Can I guarantee payments that continue after my death?

The downside many people see to annuity purchase is the worry of dying the day after they buy the annuity - in which case you get nothing and the life assurance company pockets the cash. Of course, if you get into the Guinness Book of Records for your longevity, you are the winner. This may seem a bit of a gamble. It is. However, you can improve your odds through a payment guarantee.

The income from your annuity will be payable to you for life. However, you may also choose to guarantee the payment of your pension income for an agreed period, usually 5 or 10 years. This means that if you die during the guarantee period, your pension will continue to be paid to your estate until the guarantee period ends. For example, if you have a guarantee period of 10 years and you die after 5 years, your pension will continue to be paid to your estate for a further 5 years.

If you have a joint life pension and you die within the guarantee period and your dependant is still alive, you may choose for your dependant's pension to start immediately or after the end of the guarantee period.

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Can I protect my pension against inflation?

The effect of inflation will reduce the value of your pension payments. The longer you live, the more marked the effect will become. To offset the impact of inflation you may choose to purchase an annuity that allows your pension income to keep pace with inflation up to a maximum annual increase of, currently, 5%.

Alternatively you may opt for a fixed increase between 0% and 8.5% throughout your retirement. However the initial payments will be less than that of a level pension and the higher the escalation the more it will reduce the initial payment further.

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Why do my health and lifestyle make a difference?

An annuity quotation may feel almost like a cold-hearted calculation of your personal longevity. That's because there is more than just an element of truth in this. If you are able to prove to a life assurance company that you are not likely to be very long for this world, due to ill health, they may offer a higher annuity rate to you than they would to a healthier individual.

Some companies also offer higher annuity rates for smokers, those with specified health issues and those who have worked in certain industries. This type of annuity is known as 'impaired life', 'impaired health' or, less brutally finitely as 'enhanced'.

While there could be a significant uplift in the annual income on offer by purchasing such an enhanced annuity this should not really be taken as an incentive to take up smoking, drinking to excess and wild partying late in life. However, on a serious note, you should make sure that you and your IFA include your health outlook in your calculations about which is the right annuity for you.

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What are the essential annuity points to remember?

There are five key points to remember when considering your annuity options. Many of your further decisions will be based on keeping them in mind:

  • You don't have to buy your annuity from the provider of your pension
  • Shopping around may give you a higher income
  • Don't rush or allow yourself to be pressured - this is the biggest financial decision of your life
  • Once you've bought an annuity you can't change your mind
  • Remember, unless you bought a joint life annuity, the income will cease when you die; you cannot pass an annuity on to your surviving family. Try to preserve the investments you have outside a pension

Choosing the right annuity for you is key to your financial well-being in retirement. Let us help you make the right decision!

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04 October 2007 © Moneyextra.com

 

MoneyExtra.com recommends you should consider taking independent financial advice before acting on any article. Please contact us for help with your individual circumstances if any assistance is required.