What is an annuity?
Many people believe the income they receive in retirement comes from the pension directly. In most circumstances this isn’t what happens. Over the years you or your employer pay money into a pension which builds into a ‘pot’. When you come to retire you can take up to 25% of this pot as a tax free cash lump sum. What is left over is then used to purchase an ‘annuity’ from an insurance company.
An annuity is a ‘guarantee’ from the insurance company to provide you with an income for the rest of your life. The level of income will depend on many things, not only the amount of money you have in your pension. The amount of income you will receive is dependent on the ‘annuity rate’ set by each insurance company. Annuity rates are affected by the value of government gilts, interest rates and your health.
How does your health affect your annuity rate?
An annuity guarantees you an income for life, so the longer you live the more money the insurance company pays you and vice versa if you die earlier the insurance company will have to pay you less money. So if you are of poor health, are a smoker, or have had some other form of health problem (such as a stroke, a heart attack or have diabetes) you will be offered a higher annuity rate, which could be as much as 40% more than someone in good health.
What types of annuities are there?
Although all annuities are ultimately designed to do the same thing – provide you with an income – one person may have different requirements to another. Do you have a partner? Do you want to provide them with an income after you die? Do you want your income to stay the same or increase over time to keep pace with inflation? Different annuities offer different options and the thing to be very careful of is that once you have bought your annuity (with very few exceptions) it cannot be changed and you must therefore be sure the annuity you purchase is going to meet your needs and requirements for the rest of your life and possibly your partners.
Single Life Annuity – Income is paid to the annuity holder and all payments cease upon death. Single life annuities can include a guarantee period, so if you die within this period the income will continue until the end of this period, normally 5 or 10 years. Income from a single life annuity is normally higher than for a joint life annuity.
Joint Life Annuity – Income is paid to the annuity holder until they die and a reduced income is paid to a partner for the rest of their life. The income paid from a joint life annuity is normally lower than for a single life annuity.
Enhanced Annuity – A higher income will be paid if you suffer from a medical condition.
Investment Annuities – More complex annuities that partly or wholly remain invested with the potential for the income to reduce or increase depending on fund performance.
Fixed term annuities – Income is paid for a fixed period after which the money can be reinvested into an Income Drawdown Plan or used to buy a different type of annuity.
Escalation – This is an option that can be added to most types of annuities that will increase the level of income each year. The increase is designed to keep pace with inflation and is set at a certain level e.g 3% each year or RPI to keep pace with inflation. The level of income you receive in the early years is normally lower than with any other type of annuity.
Using the Open Market Option
When you are approaching retirement your pension provider will send you details of what your pension fund is worth and what level of income you can expect. Many people simply accept the income their pension provider offers them and purchase their annuity from the same company. However most people would benefit from ‘shopping around’ at retirement and using what is called the ‘Open Market Option’. Each insurance company/pension provider will set their own annuity rate and there can be big differences between the levels each insurance company offers and it is not compulsory to buy your annuity from the same company that has your pension.
Most pension companies will send you an annuity quote based on a single life annuity with no escalation and no guaranteed period, and will not usually take into consideration your health or offer you an enhanced annuity. By simply shopping around you could increase your retirement income by anything up to 40% and even if you do shop around and cant better a deal you can always buy your annuity from your current pension provider.
Are there alternatives to an annuity?
Once you have purchased your annuity it cannot be changed even if your health or personal circumstances change so for some people buying an annuity is not the most suitable solution. A better alternative may be an Income Drawdown Plan which offers greater flexibility but is more complex and has more risks attached to it. Click HERE for more information on Income Drawdown Plans.