What is an Annuity?
An annuity provides you with a guaranteed income for life. An annuity can be bought either from your pension fund or from savings. Once you have bought the annuity you can secure a guaranteed income for life which can include your partner but you will no longer have any right to the capital.
The annuity rate offered to you is based on prevailing gilt yields, current life expectancy projections, whether you are a man or a woman, and the type of options you require e.g. a joint or single life annuity.
Types of Annuity
There are different types of annuity depending on what you are looking for:
Compulsory Purchase Annuity
A CPA annuity can be purchased using the money you have built up in your pension fund in order to secure a guaranteed income for life. The way you receive this pension annuity income can be determined by you, so you have options on whether you wish the income to be paid monthly, quarterly or annually. Income can be received in arrears or in advance. You decide on whether you want payments to increase by a fixed amount every year(typically 3% or 5% pa) or the option of linking income payments to RPI (retail price inflation) or you may prefer income payments to remain level. Additional options include whether you want the annuity income to be set on a single life basis or a joint life basis and whether you wish to build in capital protection (typically 5 or 10 years) to protect income. All these options will affect the annuity income you receive from outset and once set and annuity payments commence you cannot change the terms.
Purchased Life Annuity
A purchased life annuity (PLA) is typically bought from savings unlike a CPA which is bought from a pension fund. A PLA works no differently to a CPA (apart from the tax treatment) and can be used for a variety of reasons. For people retiring tax free cash could be used to buy a PLA to top up retirement income, alternatively it can be a useful financial planning option for those looking to secure an income for an elderly relative e.g. care home fees where there is a need to ensure that income will be there for life. The taxation of a purchased life annuity is different to a CPA and is more favourable in that a proportion of the annuity payment (determined by the age of the annuitant at purchase) will be tax free.
Impaired Life Annuity
If you have serious health problems then you may benefit from an impaired life annuity. Unlike life insurance where poor health increase the cost of cover a medical condition can help you secure a better annuity income because the insurer may take a view that your life expectancy is shorter. the lifetime of the is every month and so monthly repayments are lower. This is a specialist area and one insurer to the next have a different view on the level of uplift to give on any particular medical condition. Some annuity providers will not factor in health at all although most will provide enhanced smoker annuity rates.
Combine the advantages of an income for life but provide a certain degree of flexibility and control. There are different types of flexible annuity which have an investment link and can be correlated in line with your attitude to risk With both investment annuities and With Profit annuities there is the potential to pay you a higher annuity income in the future although there is also the potential for income to be lower by linking . There are usually options for you to adjust income levels within set parameters, and a choice of death benefits.
Immediate Vesting Personal Pension
If you are looking to secure a guaranteed income for life from your savings and you are aged between 55 and 75 you can pay a lump sum into a personal pension benefiting from tax relief on the contribution and then take 25% tax free cash from the pension and then use the balance to buy an annuity to provide a guaranteed income for life immediately.
For higher rate tax payers an immediate vesting personal pension can be even more attractive e.g. If £10,000 is paid into a personal pension, £2,500 can be withdrawn immediately as tax free cash. The remaining £7,500 is then used to buy an annuity. Current tax rules would mean the individual could claim back 40% tax relief thereby effectively reducing the cost of the annuity purchase to £3,500.
How Do I Buy an Annuity?
If you have a personal pension and you are approaching your pension retirement date your pension provider will send you a letter which will provide information outlining the value of your pension fund and the pension that could be provided on different terms if you buy your annuity with existing provider. Pension providers are obliged to inform you that you have the right to move your pension fund elsewhere if you find a better annuity deal – often referred to as the open market option, many pension providers do not make it as clear as they could that you have this right.
Having received the annuity deal being offered by your current provider you are in a position to shop around. You can either do this yourself if you are comfortable in knowing what you require or you can engage an annuity specialist to help you shop around for a market leading deal. Annuity rates are continually changing and there are alternative annuity options available for those who are looking for alternative options to consider.
In shopping around you will need to decide what type of annuity set up you want in line with your financial needs. Do you want the annuity on a single or joint life basis if you have a partner. If on a joint life basis do want the annuity to reduce on first death by 1/3rd, 50% or not at all. Do you want the annuity to escalate over time e.g. 3% pa or 5% pa are typical, or by retail price inflation (RPI) or do you want income to remain level? Do you want payments to be made to you monthly, quarterly or annually, in arrears or in advance?
If you decide to go with another annuity provider the process in setting up an annuity is relatively painless. The new provider will provide you with a relevant annuity application form requiring your authority to have funds moved from your existing pension provider. The whole process should take no more than 4 weeks.
If you are taking out an impaired health or medical annuity then the process may take longer as medical reports will probably need to be seen by the new company before agreeing to proceed.
Top Ten Annuity Tips
1. The annuity open market option means you are not obliged to accept a quote offered by your existing pension provider. You have the option to move your fund to a pension company that offers better annuity rates.
2. Ensure you shop around for the best annuity rates. Get annuity quotes from more than one provider. The latest rates can be obtained from weekend newspapers best buy tables, online websites and specialist annuity companies.
3. If you are a smoker or have a medical condition you may be able to get better deal. If this is the case you should get annuity advice. Even if you overweight, have high blood pressure or high cholesterol this may work in your favour in getting you a better annuity rate.
4. If you opt for a level annuity over time your income will depreciate in real terms as inflation takes effect. Consider an annuity that increases by a fixed amount every year or an annuity linked to retail price inflation. These options are expensive but provide peace of mind and need to be considered.
5. Consider building in a 5 or 10 year guarantee to protect your income in the event of early death.
6. With a joint life annuity the rate you will be offered will be impacted by whether you decide to keep income the same at first death or where it is set to reduce on first death. Annuity rates for women are lower than men because annuity providers factor in mortality into annuity rates and women generally live longer than men. Think carefully about your future income needs.
7. Consider the merits of flexible annuities which provide the potential for a growing income over time. Flexible annuities range from investment linked annuities to With Profit annuities which have different characteristics.
8. In arranging your annuity give yourself plenty of time before you will need the first income payment to meet living costs. While setting up an annuity is generally straightforward delays can be caused because of pension administration delays and if your annuity requires underwriting where you are looking for an enhanced or impaired life annuity.
9. Read the FSA leaflet Money Made clear which provides a useful guide to the open market option and the annuity process.
10. If you are unsure of your annuity options speak to an annuity specialist