All About Annuities
December 1, 2010
Historically, one of the restrictions with personal pensions, SIPPs and defined contribution schemes is that you usually have to use the bulk (generally 75%) of your pension fund to buy something called an annuity before you are 75 years old. You can take up to 25% of your pension pot as a tax-free lump sum when you retire.
The new government has announced that the requirement to buy an annuity by age 75 will be relaxed from April 2011 onwards, although the final details are still being worked out and it is expected most people will still take the annuity route.
What is an annuity?
An annuity gives you an income for life and they are sold by insurance companies. You give the insurer your pension pot and they promise to pay you an income for life.
The rate you get will depend on a number of factors. The younger you are, the less you'll get each year as the insurance company is likely to pay out for a greater length of time. If you're a woman you'll get less as you're expected to live longer. You can also get annuities that continue to pay until both you and your spouse dies (called 'joint life', as opposed to 'single life').
You can get a 'level annuity', which is an income that remains the same till you die. You can also get annuities that increase by 3% per year, or annuities that increase each year in line with inflation (using the 'Retail Prices Index' - RPI). With both of these 'escalating annuities', you'll have to accept a lower starting amount.
On top of that, you can also shop around at different companies to see who is offering the best rate - known as the 'open market option'. You don't have to buy an annuity from your pension provider, and the difference between the highest and lowest payers can be substantial, sometimes as much as 20%. In addition, if you smoke or have one of a range of medical conditions, you may also get a higher income by choosing what is known as an enhanced or impaired life annuity.
Plus you can choose a 'guarantee period', typically of five or ten years. This means it'll continue to pay the full income to a partner or to your estate if you die within that period. Opting for a guarantee period reduces the size of the annuity you can expect.
Factors that affect the size of your annuity
||You can find better annuities if you compare
annuity rates from several providers
|The size of your
|If you have a bigger pot you get a larger annuity
||Men get better annuity rates than women
||Smokers get better annuity rates
||Older people get better annuity rates
|Single-life annuities have better rates
|Level annuities start higher, but escalating
annuities increase each year
|You get a better rate with these annuities
*If you get a joint-life annuity, the age and gender of your partner, and even whether they smoke, might affect the annuity too.
All told, choosing an annuity can be a decidedly tricky business and you only have one shot at it. Once you've bought an annuity you can't then go back and change your mind if you find a better deal. As your choice of annuity can dictate your income for the rest of your life, it's not a decision to take lightly!
Annuity rates are much lower than they have been in the past. In fact, they've roughly halved over the last 25 years. At the time of writing, to buy an annuity income of £10,000 a year that increases in line with inflation, a 65 year old man, who wants his wife to receive half of his pension if he dies before her, will require a pension pot of nearly £250,000.
In April 2006, new pension legislation came into effect. Up until the age of 75 you have the option of either taking out an annuity or an 'unsecured pension'. An unsecured pension is similar to the previous 'income drawdown' system where you draw an annual income while the remainder of your fund remains invested. You're able to take a minimum income of £1. The maximum you're allowed is 120% of a level single life annuity. So if, with a single-life annuity, you'd get £1,000 per month, you're allowed to take up to £1,200 as an unsecured income. Unsecured pensions are more risky, but unlike annuities you can pass on your remaining pension pot to dependants (although there is a tax charge).
The new regime
From April 2011 onwards, you'll have two options if you don't want to buy an annuity. Both involve drawing an income from your pension pot while leaving the rest invested, hopefully to rise in value of course! Generally, these routes will only be practical for those with larger pension pots.
Firstly, you can opt for 'capped drawdown'. This will operate in a similar fashion to unsecured pensions but you will be able to continue drawing an income beyond the age of 75. The annual limit of the cap is still being decided, so it may be lower than the 120% rate that applies with unsecured pensions.
The second option is 'flexible drawdown'. Here you will be able to drawdown as much as income as you want, as long as you can demonstrate you have sufficient other income (i.e. another pension) that you won't end up relying on the state. So you might be able to annuitise part of your pension and take the remainder as either a capped or flexible drawdown.
Of course, the government still wants to make sure any money left in a pension fund when you die is taxed, in order to recover the tax relief given while you were paying into the fund. So it's intended that any remaining money will be taxed at 55%, although it won't then be subject to any inheritance tax. If you die before the age of 75 and haven't touched your pension, then it will remain tax-free.
Should you take out an annuity?
An annuity is a means by which you can ensure than your pension fund runs out exactly when you do. It doesn't matter if your retirement lasts 50 weeks or 50 years it'll keep paying out. But when you die, that's it. There is (usually) nothing left for you to pass on to your descendents. That's what annuities do -- they give certainty.
As always, though, there is a big price to pay for this certainty. In order to guarantee to pay you a particular amount for the rest of your days, the insurance company has to back up its promise to you with some very safe investments. In fact, your annuity is effectively backed by the safest investment of all -- UK government bonds or gilts.
Herein lies the main drawback. Gilts are all very well for a short amount of time but over long periods of time, they have not offered a great rate of return. Annuities made a lot of sense when retirements lasted for only a few years, but now people are living longer and longer in retirement, the argument is less clear cut. Thirty years is certainly not unusual these days and it's getting longer still. Investing for these sorts of period is the province of 'real assets' like shares and property. After all, with the inflation we've seen over the last few decades, an annuity from the 1970s would now be looking decidedly inadequate.