Guide to Annuities

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What is an Annuity?

An Annuity is a financial product that you buy with part or all of your pension pot. Once purchased the annuity pays out a regular, guaranteed amount for a set period of time (usually until death). In short you exchange a lump sum amount from your pension pot in exchange for an ongoing regular payment.

How does an Annuity work? As a very simple example, you could trade £100,000 of your pension pot in exchange for an annuity which pays you £4,000 every year for the rest of your life. These figures are made up for this simple example and as we will see there are many factors that can determine how much you will get in exchange for your lump sum payment, including the features you may want (such as the payment increasing with inflation) and your personal situation (such as your age, health etc).

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Do I have to get an Annuity?

No! You no longer have to get an annuity. Historically this was the case but hasn’t been so for several years. Since no longer being compulsory, annuity’s have become less popular, although they are still an important part of planning for retirement and often form part of a pension or retirement plan. So although it is no longer a requirement to purchase an annuity, they should certainly be considered alongside other products when working on your retirement plan.

Some pensions may pay out a guaranteed pension income which seems similar to an annuity (as it does the same job; provide a regular guaranteed payment) but is technically different with different rules applying to these payments. If you are unsure contact your pension provider or a pension adviser to make sure; many advisers (like ourselves) are usually happy to answer general questions you may have for no charge.

What are the alternatives to an Annuity

Purchasing Annuities are rarely the first choice when it comes to pension and retirement planning these days. This is less to do with the fading attractiveness of annuities and more to do with Pension Freedoms which gives everyone much more choice when it came to what do with their pension pot.

The other main option for taking income from your pension pot is called “Drawdown”. Drawdown broadly involves taking money from your pension pot as and when needed, and keeping the rest invested. Drawdown comes with a lot more flexibility and there are a variety of options in how it can be managed, but it does not come with the certainty of income that you can get with an annuity.

Another option for drawing funds from your Defined Contribution pension is to withdraw lump sums as and when they are required. A lump sum is simply a chunk of cash which you take out of your pension pot. Part or all of this may be tax free with the rest having income tax payable. Withdrawing funds in this way can be convenient but also may have consequences that need to be taken into account, such as triggering a reduction in your annual allowance or an increase in tax.

There are other ways of withdrawing funds from a defined contribution pension and its likely that the most efficient way will involve a combination of several options.

Moving some or all of your pension pot to drawdown or accessing with lump sums do have consequences which would need to be considered, although this depends on your personal situation. A good independent financial adviser will be able to work out which combination of options works best for our situation, maximising income and avoiding and potential costly mistakes.

Types of Annuity

There are several different types of annuity:

Lifetime Annuity – pays you a guaranteed income for the rest of your life. A good option for peace of mind or if you have any concerns that you may run out of funds.
Fixed-Term Annuity – pays out a guaranteed income for a fixed amount of time, most commonly between 5 and 10 years. There can be an option to end the annuity early and also the option of a “maturity bonus” which pays out at the end of the term.
Enhanced Annuity – these are for those who have a reduced life expectancy due to health problems such as cancer and pay out more than the standard equivalent. They are also knows as “impaired life” annuity’s.
Investment-linked Annuity – these are part guaranteed income and part linked to investment performance. There is a potential for greater income but there is also greater risk if the investments do not perform well.
Purchased-life Annuity – this annuity can be purchased with money not in your pension pot and as a result the main difference is the tax treatment. Capital protection is a popular feature as well as it guarantees that if the annuity holder dies earlier than expected then an element of capital will be returned to the estate.

Please note that the above are very simple summaries and are provided to show the range of annuity types that exist.

Is Annuity Income Protected Against Inflation?

There are different version of annuity’s that determine by how much your annuity payments will increase over time.

Inflation Linked Annuities – The payments received from this type of annuity will rise in line with the national rate of inflation (usually RPI – the Retail Price Index). There is a cost for this feature however, so you will need to either pay more to have the same amount of payment inflation linked or receive a lower starting amount but one that comes with inflation linking.
Escalating Annuities – An escalating type of annuity will rise each year at a fixed rate. e.g. an increase of 2.5% each year.
Level Annuities – This type of annuity will pay out the same amount of income every year. They will have a higher starting point than an equivalent escalating annuity, but they can leave you exposed to inflation which will make your annuity income worth less over time. Even low levels of inflation can have a significant impact on your standard of living over a prolonged period of time.

As with many decisions around Annuity choices, which are the most suitable depends on your personal situation. Your health, your wider retirement plans, and whether you want to lave an income to your spouse after death are some of the factors to consider. A Pension Adviser will be able to discuss with you in more detail and help select the most appropriate type of annuity.

Which Annuity is Right for Me?

Unfortunately there is no simple answer to this question. Either by your own research or working with your adviser, you should be able to gain an understanding of annuities and what each type can do for you. However, an annuity is just one part of a retirement strategy and when choosing what type of annuity to purchase (or if at all), then it is essential to look at it alongside the rest of your plan.

There are many things that can be done with retirement planning these days to help maximise your pension income, and the solution will likely involve a mix of different financial products, such as Pensions, Annuities, and others. While Annuities provide a clear benefit (guaranteed income) this does come at a price and it’s important to know if there is another, cheaper, way of achieving the same outcome.

It is key to know exactly what you need out of an annuity, as you are paying for the different features and benefits of each type. As annuities are almost impossible to change once taken out it is important that you make your decision carefully and make sure you examine all the other options and fully understand what benefits you are paying for and if they are value for money for yourself.

What are the Benefits of an Annuity?

Guaranteed Income. Gives peace of mind that you will always have a minimum set income. No matter what happens to the stock markets or if you live until 120, your income will be paid for life.
Income Protection. The option to track inflation or to include set increases in the income will help protect spending power as costs rise over time.
Financial Security. Knowing that you have a guaranteed income can help you better plan our future and also help better plan the investing of the rest of your pension pot.
Extra Protection. Your annuity income could continue after you die if you’ve chosen certain options when you apply, such as guaranteeing a payment period, passing the annuity onto a spouse, tracking inflation or protecting capital are all available to help tailor your annuity to your situation.

What are the Disadvantages of an Annuity?

Locked in. Annuities are virtually impossible to cancel or change after being bought.
Future Annuity rate Rises. Annuity rates might rise in the future, but you won’t benefit from this if you have already taken your annuity out.
Age and Health. It possible that you wont be able to get the full benefit of the annuity you paid for due to ill health or an earlier than expected death.
No fund left over. Unlike with entering drawdown with your pension, there is no remaining “pension pot” to benefit from growth with the funds already used to buy an annuity. And as there is no pension pot remaining there is no value to pass on in your estate (apart from a few situations).

What's the difference between a Pension and an Annuity?

Broadly speaking the main difference between a Pension and an Annuity is that a pension is a “pot” into which you save into during your lifetime whereas an Annuity is something you buy after you retire to provide you with a guaranteed regular income.

Pensions are often thought as something you receive after you retire, but this is not technically true. The pension is the “fund” that you build up during your working life and is either a Defined Benefit Pension or a Defined Contribution Pension. A Defined Benefit pension pays out a guaranteed regular income for life after you retire (and so appears similar to an annuity). If you have a Defined Contribution pension then you need to decide how to turn your pension pot into a retirement income, with there being many options available, one of which is to purchase an annuity.

These pension arrangements are all separate from the State Pension, which you can receive from State Pension Age and is mainly based on your lifetime National Insurance contributions. A private pension can be seen as a way to supplement your state pension, to help achieve the post retirement lifestyle you want. More information on the UK state pension can be found here – Understanding the UK State Pension.

What happens to my Annuity when I die?

If you die, your annuity payment will usually end and the funds you used to buy your annuity are effectively gone. However there are a number of options that you can take to ensure a surviving beneficiary can still benefit from your annuity:

Guarantee periods. It is possible to apply a “guarantee” to an annuity which means the income will continue to be paid even if you die (during the guarantee period). This guarantee period can last no longer than 10 years from the date of policy inception and the payments will end at the end of this period. Adding a guarantee period will either raise the cost or lower the income of the annuity, as the feature needs to be included in the cost of the policy. The guaranteed payments will be taxable in the hands of the recipient.
Annuity/Value protection. This allows the person taking out the annuity to protect the value of the money they paid to originally buy the annuity. A lump sum can be paid on death to intended beneficiaries with the lump sum being the difference between the price paid for the annuity less any payments already paid.
Joint Life. A Joint Life Annuity pays an income for the rest of your life, and then continues to be paid to your chosen beneficiary (usually a spouse/partner) for the rest of their life upon your death.

Advice and Next Steps

Hopefully this article has helped give a good background in annuities and what they can do for you. It’s important to note that the above article is meant for educational background information only and should not be relied upon to make any financial decisions. Annuities should be considered as part of wider financial planning and, as it is virtually impossible to cancel once taken out, you need to be sure you’re making the right decisions.

If you are considering securing a lifetime income via an annuity then we can certainly offer advice and recommend exactly which option or combination of options would provide for maximum benefits. We can also help if you are earlier on in the process of thinking about retirement and want to build the foundations for a good retirement with an effect plan, ensuring that you are putting enough away today and that it will grow enough to give you the lifestyle you want. This can be part of a wider Financial Plan or standalone Pension advice.

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