What is an annuity ?
An annuity is a secure regular income usually paid for the rest of your life, which is normally built up via a pension plan throughout your working life. The annuity is the regular income that is bought with your pension fund at retirement. Once set up, the annuity is normally fixed and offers a secure income for the rest of your life, although there are options to fixing the income, for example you could have an increasing income via an indexed linked annuity.
The amount of pension income you receive from the annuity will be dependent upon your age, whether you are male or female, the size of your pension fund and even other circumstances, such as the state of your health or previous occupations.
As there are various options to select for your annuity, it is always a prudent idea to seek advice.
Are they flexible?
In the main no! The majority of annuities purchased cannot be altered, surrendered for cash or transferred. This makes it absolutely essential to choose the options that suit your circumstances best. So when you are ready to convert your retirement fund into an income via an annuity take some time to consider the options available.
What options are available if I decide to take an Annuity?
1. Single life annuities. These pay only to the person named in the annuity and once they die the annuity payments (income) stop. There is no provision for remaining partners or dependents. If you do have financial dependents, you really do need to consider what they will live on after you die and the annuity has ended.
2. Joint life annuities. Here the annuity pays its income until the annuitant (purchaser) dies, it then carries on paying to a named partner or dependent for the rest of their life too, usually at a reduced rate.
3. Level annuities. These will pay the same fixed amount each month for the rest of your life.
4. 'Escalating' or index-linked annuities. Here the income paid will increase by a fixed percentage (e.g. 3% or 5%) or alternatively by the rate of inflation each year. This type of annuity pays much less at the start, but the income in the later years of your life will be higher in real terms than for level annuities. Should you have no other protection against inflation, it would be important to consider the benefits of an escalating annuity. Alternatively, some consider the lower starting income of less value, but it is important to remember that around 3% inflation per annum can have the effect of halving the real value of your income within 20 years or so.
5. Guarantee period. Annuity companies typically offer a five-year guarantee period on your income, this means if you were to die within five years of buying the annuity, the company will still carry on paying your income to your estate upto the fifth anniversary. However, you can select upto a maximum 10-year guarantee period, this has the effect of reducing the income slightly, compared to the five year guarantee.
6. 'Impaired life' or 'enhanced rate' annuities. If you are a smoker, have a history of illness, you could obtain a higher annuity income. Some insurance companies will pay a higher income if you have certain medical conditions. Statistics show that people with some health conditions have a shorter than average life expectancy. These specialist insurers use this to your advantage: they will pay you a higher income because they calculate that, on average, your income should be paid out for a shorter period of time.
7. Investment linked annuities. The income you receive will depend upon the performance of the chosen investment markets. A proportion of your pension fund remains invested, in products like unit trusts, investment bonds or with profits funds, in the hope that the eventual payouts will be higher later in your retirement, but this is not guaranteed. These may not be suitable for you if you don't want to take any further investment risk
8. Income drawdown. This option is not an annuity. It allows you to continue investing your pension fund whilst taking some income out. Again, this carries investment risk, and will typically have higher charges, currently a pension income must be taken by age 75. USP/ASP will not be suitable for all customers. Unlike an annuity there is no guarantee that an income will be paid for life. Withdrawals may erode the pension fund and annuity rates may be lower in the future, leading to a reduced level or loss of retirement income.
The value of investment income from them can fall as well as rise and you may not get back the full amount invested.(See below).
Do I have to buy one?
No, not necessarily. Many of the pension rules governing retirement were changed on the 6th April 2006 (A Day). But tax rules still state that individuals must use their retirement fund to secure a pension income by age 75. However, A Day created an exemption as a result of lobbying by the Plymouth Brethren, a small religious group who opposed the rule due to their opposition of insurance. As a result you are now allowed to set up what is known as an Alternatively Secured Pension (ASP). Under ASP, the pension fund remains invested and the individual draws an income from it. There are strict rules about how much income may be taken. Any remaining pension fund must be used to provide an income for your partner or financial dependent upon your death.
What are the alternatives?
Unsecured Pension (USP)
(also known as Pension Fund Withdrawal or Income Drawdown)
Unsecured Pensions are a potential alternative to buying an annuity, as they allow the pension plan holder to draw an income from their pension fund while the fund remains invested. The income level is restricted to a maximum of 120% of the level lifetime annuity payable to a single person of age and sex. You can opt to take zero minimum income and also choose to buy a lifetime annuity at any time. As previously mentioned under option 8 above, please be aware of the stated risks of income drawdown.
Anyone can use USP, however, some pension schemes will not operate USPs for small funds (£50,000 or less). If you are in an occupational money purchase scheme you may be able to use a USP, if the scheme rules allow it. If you are in an employer’s scheme that doesn’t offer a USP and you want to use it, you must first transfer your pension rights from that scheme into a personal pension scheme. In this case you may find that you could lose any protected entitlement to a tax free cash sum greater than 25% of the fund value. As always it’s a good idea to take advice.
Currently the remaining pension fund must be used to secure a pension income by the age of 75.
Alternatively Secured Pension (ASP)
On reaching age 75, any remaining pension fund can be used to purchase a lifetime annuity or an Alternatively Secured Pension (ASP). ASP operates in a similar way as USP, but with some different rules:
- The maximum income you can withdraw is about 90% of a level single-life lifetime annuity and the minimum is 55%.
- These limits must be reviewed every year.
- Regardless of your actual age, the maximum income will be based on age 75.
The funds in ASP are invested in a similar way to a USP arrangement and are therefore subject to investment risk. You are able convert your ASP into a lifetime annuity at any time.
Should death occur, whilst in ASP, any remaining invested fund can either be used to:
- Provide a spouse, civil partner or dependant’s ASP for someone over age 75, or
- Provide a spouse, civil partner or dependant’s USP for someone under age 75, or
- Provide a pension annuity for a spouse, civil partner or dependant, or
- Provide a charity lump sum death benefit, or
- Provide a transfer lump sum death benefit (where there is no surviving dependant).
Where remaining funds are subsequently used for the benefit of a spouse, or civil partner, or dependant, then there will be no immediate charge to Inheritance Tax (IHT). However, if on the subsequent death of that person there are still unused funds remaining, those unused funds will be taxed for IHT as if they had formed part of the original pensioner’s estate on death.
Depending on how the original unused funds are used by any spouse, civil partner or dependant, there could be a further tax charge imposed on the net remaining funds after IHT has been paid.
A Transfer Lump Sum Death Benefit paid to a charity will not attract IHT.
The responsibility for paying any IHT liability rests with the pension scheme administrator. This means that the tax liability can be paid directly from the unused funds.
Levels and bases of and reliefs from taxation are subject to change and their value depends on the circumstances of the individual investor.
Do I have to accept my pension company's offer?
Definitely not. Your pension companies will want you to choose their annuity offerings, but the rules state that you don't have to. Everyone has the right to use the 'open market option', by shopping around and choosing the annuity that suits their needs best. A starting point could be to consult Pension Annuity Expert. There can often be a substantial difference between the highest and worst annuity rates available, often amounting to thousands of pounds over the average investor's retirement.
What else do I need to know?
Some older style pension policies have valuable guarantees that mean they will pay a much higher rate than the current market allows, this is due to the inclusion at inception of Guaranteed annuity rates (GARs). This sometimes valuable inclusion could result in an income twice or even three times as high as policies without a GAR.
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